Why You Need to Short Stocks Right Now

Gary Gibson: Dan, you said the summer should be the best environment for short selling since 2008. That implies a lot of declining stocks. How bad is the outlook for stocks really and why?

Dan Amoss: Okay, well I start from the assumption that most economists and analysts are ignoring the importance of balance sheets. There’s way too much bad debt in the global economy, and governments and central banks are trying to paper over these bad debts.

And the consequence of this is that governments will eventually reach the limits of what the market will allow in terms of debt to GDP ratios. At that point, it will be hard for the economy to both grow and service the incredible burden of debt that it has.

Overindebted balance sheets at all levels of society tells me that this is not a typical economic cycle. Yet the stock market is priced for a typical economic cycle, and factoring in record earnings and profit margins in 2011 and 2012.

Stocks are expensive right now, based on my favorite method of valuing the broad stock indices, which is the Shiller PE ratio, the work of Yale economist Robert Shiller. This PE ratio is defined as the price of the S&P 500 divided by the average, inflation-adjusted earnings over the past 10 years. This ratio is about 20 right now, far above the historical average of about 15.

At the end of long bear markets, the Shiller PE shrinks to between five and ten. So over the next few years, the broad market could go down another 50% through some combination of falling prices and rising corporate earnings.

Most stocks are likely to fall this summer, simply because efforts of governments and central banks to paper over bad debts will hit some serious roadblocks, particularly in Europe and in the U.S. mortgage market. Any company that needs to constantly tap the corporate bond market or its line of credit could see much more weakness this summer.

I’m always looking for stocks that can fall faster than the market. Typically, I like to drill down to specific sectors and stocks to find the ones that are the weakest and/or the most expensive.

Gary: Could you give a couple examples of that?

Dan: Sure, an example of an area that I’ve been focusing on is companies exposed to commercial real estate — that includes most REITs. REITs trade like stocks, and they own portfolios of commercial real estate. They typically pay out 90% of their earnings as cash dividends. REITs reached an extraordinarily high valuation in 2007. They were priced for for continued increases in rents as far as the eye could see. And people were using extraordinary amounts of leverage to buy these properties.

And then when the 2008 crisis hit and financing dried up, you saw affordability collapse, in terms of what types of properties investors could buy on a leveraged basis.

Since the 2008 panic, the Fed pulling rates down to zero percent has helped REITs out a lot, but now you have a big overhang of what I call zombie properties that will restrain the appraised value of the overall index of commercial real estate.

Gary: Now, in terms of the feds holding down interest rates, you expect this will result in bigger problems?

Dan: Well, it delays the ultimate resolution of the commercial real estate bubble that peaked in 2007. What the market needs to restore health to commercial real estate is fresh equity. Which means you need liquidations of the old owners’ interest in kicking hte can down the road with serial refinancings, have their equity wiped out, and bring in new buyers with the capacity to inject sustainable levels of equity into these properties.

For most commerical properties purchased with high leverage between 2005 and 2007, the debt to asset ratios — if they haven’t been foreclosed on — are now well over a hundred percent. In other words, the investors are underwater, like a homeowner with negative equity. Owners with negative equity have little incentive to properly maintain their properties. Properties that aren’t maintained, lose many tenants as leases roll off, which accelerates a liquidity crisis. In this type of situation, which is rampant, if the banks don’t foreclose early on, and just roll over loans to insolvent borrowers, the ultimate loan charge-offs when forclosure becomes inevitable will be even larger.

So going back to the zero percent effect: for banks, the lower interest rates are, the lower they can justify on their income statements how long they can hold these non-cash flowing properties.

Gary: I see, and another example if you have one handy?

Dan: Yeah, another area I’m focusing on is the consumer electronics companies that produce in the U.S. and export to Europe. One in particular generated most of its 2009 operating earnings in Europe.

This company is heavily exposed to the Euro/dollar exchange rate. Its stock doubled off the lows in 2009, yet the company is facing massive long-term head winds in their core product. Technological shifts will make it obsolete in a decade.

Yet the market is pricing this stock like we’re in a typical economic recovery and it won’t be hit by competitive pricing pressures and a weak European economy.

Gary: This is not your garden variety contraction; it’s not just a regular recession. But before I move on, two things I figure would be hit a lot by the lack of credit were things homes and like electronic toys seem to be the biggest beneficiaries of cheap credit when it was available for the past, I don’t know how many years. Does that sound right to you?

Dan: Yeah, that sounds right. Easy credit can impact the economy in a lot of destructive ways by sending all sorts of false signals about what sustainable demand really is to producers.

Producers gear up equipment to service that demand, and then when the credit’s gone, the pain, the adjustment is wrenching. We see this now, not only in the U.S. consumer economy.

There’s risk of German factories selling into Southern Europe. There’s risk of a big adjustment there, loss of sales and margins. And same thing with China and the U.S. relationship, balances in the global economy will take a long time to work out.

There will be a lot of wealth destroyed in the process.

Gary: Speaking of wealth being destroyed, what effects do you see coming out of the deepwater drilling moratorium for the Gulf of Mexico? The people in government who are instituting it, they probably don’t think about these things at all — about perverse and unintended outcomes.

Dan: Yeah, there’s no doubt that this is a huge environmental catastrophe, but it seems like government regulators are trying to make this even worse.

Whereas the fishing and tourism industry was hurt by the first order effects of the spill, by imposing this six month blanket moratorium on the rest of the off shore drilling industry, we’re going to start seeing rapid production decline rates kick in on a lot of these off shore wells.

We get in excess of one million barrels of oil per day of oil production in the U.S. from deep water wells. The nature of these wells, the decline rates of these wells, dictates that you’ve got to keep drilling new prospects very actively to avoid a scenario of contracting oil production in the Gulf.

A report from Morgan Stanley that came out last week claimed that in an extreme worst case scenario — if deepwater drilling is permanently banned in the Gulf of Mexico, it will drive today’s 1.2 million barrels of oil per day of deep water oil production down to zero over a four to five year period.

And considering the state of big oil projects around the world and the ever growing demand from emerging economies, we simply can’t afford that level of decline in production. You can have a situation a couple of years from now where high oil prices will continue to crowd out any discretionary spending among U.S. consumers, which would be very bad for a lot of stocks.

Gary: So it’s going to pinch the consumer’s wallet and we’re talking everything being affected.

Dan: Exactly. The average American household spends anywhere between five to ten percent of their income on gasoline and transportation. That can easily go much higher. In developing nations, the cost of transporatation is a much higher percentage of the household budget, yet demand’s still growing.

Gary: That sounds like a recipe for disaster. So you have the government claiming it’s going to stimulate the economy, which is probably not a good idea in the first place; and then they’re doing this, which will create a huge drag on the economy. For stocks, it’s just sounding pretty bad.

Dan: Exactly.

Gary: Speaking of government intervention — I want to talk about short selling, which government tries to portray as evil, as this destructive, unpatriotic act, but don’t short sellers serve an important function, especially now they’re going to have as you mentioned this summer coming up, looks like they’re going to have just a field day? They do something important for the market.

Dan: The most important thing that short sellers do is they communicate, especially during the midst of bubbles, when the emperor has no clothes. They point out inefficiencies in pricing. Famous short sellers were among the first to warn about credit excess a few years ago and housing bubble.

Short sellers basically sell into the peaks of bubbles and provide liquidity to panicky sellers near market bottoms when they buy to cover short positions. When people are panicked and wanted to get out, and there are few providers of liquidity, they’re one of the few consistent providers of liquidity in really weak markets.

And secondly I would say based upon history, mostly because the tide tends to go against short sellers over the long term, they have to be twice as rigorous in their analysis. You can’t afford to be wrong as often when you’re a short seller, especially when you’re betting against a company using accounting shenanigans to inflate their earnings.

So those are two main reasons that short selling benefits the market. There are several more, but those are the first two that come to mind.

Gary: Sounds like short sellers have to be very smart. So what kinds of things would happen — there was a ban on it for a little while, kind of a populist thing to demonize short selling.

What happens when there aren’t short sellers? They provide this important function; say they’re stopped from doing it, which I guess could happen, again.

Dan: The last few instances where they’ve banned short selling led to a period when markets typically went into free fall, and we saw that in the fall of 2008 in the U.S. with the ban on shorting financial stocks.

The biggest period of decline occurred after the bans. And the reason that is, is because so many market participants, everyone from long/short hedge funds to convertible bond investors, use short selling as a key component of their investment strategy.

So when you take that component away, those investors typically just withdraw from the market. And when you have a mass amount of investors who tend to be very active traders withdrawing from the market, liquidity evaporates. And the last time you want liquidity to evaporate is during a panicked period.

It tends to make things much worse and has never resulted in the outcomes that the bureaucrats and regulators are seeking by banning short selling.

Gary: Imagine that.

Dan: They think it will end selling, but what really causes markets to crash is no bidding. Banning short selling often results in a market with no bids.

Gary: Would you say that’s fair to say that markets tend not to get so out of whack when they are allowed to correct themselves automatically as opposed to having things but in their way that are very un-market like…basically politics and political decisions?

Dan: Yes.

Gary: Okay, so the short sellers fit right in the Whiskey Bar really easily. Do you have any famous stories or examples of short selling?

Dan: The best example in my mind of how short sellers provide value to investors and society at large is the story of Jim Chanos and Enron. Enron was a darling stock in the late 90s and up until the year 2000. Every analyst on Wall Street loved it; brokers were pushing it to their clients.

You have this hedge fund maanger dedicated soloey to short selling, Jim Chanos, who’s known for his skill in forensic accounting. He looked into all the off-balance sheet entities, figures out what’s really going on, and concluded that the company was basically a big Ponzi basically. So his hedge fund sold short the stock.

Chanos was selling near the peak as the public was buying; if Chanos’ fund hadn’t shorted it so aggressively, the stock likely would have kept going up because it had the nature of a Ponzi where because it was going up, it was drawing in more capital, which in turn cause it to go up even further. And because Chanos was selling short , he stopped a lot of investors from losing even more money by prompting them to dig deeper and ask harder questions in order to really understand a company that was ‘all hat and no cattle.’

Gary: He corrected an imbalance. He was the market that worked, essentially. Regulators say they need to be there to prevent Ponzi schmes and things that’s rob the investor, but he was doing their job.

Dan: If regulators want better enforcement of the security laws, they should do everything to listen to, rather than hamper short sellers, especially in situations where ridiculously promotional companies are constantly in the market raising capital from gullible new investors.

Gary: We talk a lot about economic Armageddon. Is this it?

Dan: I wouldn’t go as far as saying that quite yet because what we have basically what I talked about earlier regarding the unaffordable debt problem. The U.S. can get away with effectively socializing the losses from all of the bad debts in the banking system for a while, but it’s going to eventually show up in disappointing economic performance, especially amongst small businesses.

And when jobs and tax receipts don’t pick back up as expected, deficits are going to surprise on the down side. We have not seen the last of the Federal Reserve’s quantitative easing.

I think we’ll see more of what I call the ‘deflation trade’ for the next few months, which means Treasury bonds will probably keep rising (yields falling) and most stocks will keep falling; the Federal Reserve is saving its ammunition until everyone’s afraid of deflation and they’ll start another big round of Treasury bond and mortgage buying, at which point depending upon how savers and global providers of capital react, it could be very, very troubling.

In a scenario where the bond market loses confidence in the integrity of the currency, we could see rising yields on every type of bond despite a weak economy; for most investors, this would qualify as economic Armageddon. Stocks and bonds would both fall in value under this scenario.

This ultimately to me adds up to why you should own gold because the confidence in the monetary system will eventually collapse if governments and central banks remain on their current paths.

Gary: They’re going to do it again.

Dan: Exactly, the key point is central banks want to maintain this low inflation outlook as long as they can. As long as the market believes that, they can keep expanding their balance sheet and supporting asset prices as much as they can get away with — , until the market says no. And we’re a long way from that, I think; we’re at least a few years from that.

Gary: Wow, but in the mean time, this summer seems to be a very good environment for falling stocks. We’re not at the end of the world quite yet, or the end of the monetary system. So there’s still a lot to be done with the falling market, which is what you do; right?

Dan: Right.

Gary: So what is the one thing that we just can do right now to make sure that we won’t be wiped out by this market that’s going to be falling a lot in this very short term, but we’re not at the point where we have to get your golden bullets quite yet, but in the near term, what should they do?

Dan: I think number one is making sure your portfolio has a heavy cash component. Number two for the stocks that you do own, be very confident in their prospects, that they’re companies that are going to benefit from the likely trends in the global economy that are sustainable, like energy and food and water and basic materials, basic necessities. The stuff that emerging economies are working hard to afford, and that most Westerners take for granted.

And number three I think if you want to hedge the market risk in those stocks, the opportunities are great to selectively short sell certain companies that will be victims of this economic scenario.

Gary: Yeah, I hear that you’re very good at that last part. Thanks, Dan. See you around the Whiskey Bar.

Gary Gibson and Dan Amoss
Whiskey & Gunpowder

June 9, 2010