The Quandary of Short Selling – Even in a Bear Market!

by Victor Sperandeo with the Curmudgeon

Important Background:

As the Curmudgeon and I have noted in many blog posts, today's financial markets are completely controlled by "Central Planners" who are (for the most part) the Fed and global central banks.

The Federal Reserve is made up of 19 unelected bureaucrats, academics, and bankers. It is owned and controlled by secret shareholders (who get a 6% dividend every year- even in a ZIRP environment), and the regional Fed banks. Let's now examine the real risk of who traders are dealing with (the Fed), and their mental state towards capitalism and free markets.

Interview on the Fed's Mindset & Desire to Control Everything:

In a February 15^th interview on RealvisionTV (subscription video website), Pippa Malmgren, PhD¹ spelled out the Fed's mentality and Chairwoman Yellen's beliefs. Pippa said something like the following (via my transcription of her remarks, which is accurate but not an actual word for word quote):

“Fed Chairwoman Janet Yellen is extremely disdainful of financial market traders. They are stupid people, in her opinion, because they cannot hold a thought in their heads for more than 30 seconds before they change their minds. (Victor notes: this is known all over the world as "TRADING") In other words, active financial market participants cannot be trusted with the future of the economy!

The Fed arrested control over the vehicle (the markets) from the crazy financial market drivers, who were and are drunk with hubris. Now the Fed wants to have control of everything. Yellen thinks she can control it all: interest rates, the level of the stock market, yields on bonds, etc. Moreover, she can do it simultaneously, which we know she can't. Yet her door is not open, her ear is not open, so a lot of the alarm bells we see in the markets they (the Fed) doesn't want to see. (Could that be denial of reality while trying to control everything?). Thereby, it is highly unlikely the Fed will reverse course on interest rates."

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Note 1. Pippa's father was chief trade negotiator for the UK under four US Presidents-Kennedy through Ford. She was an advisor to George W. Bush. A very connected person indeed. She founded and a runs the DRPM Group consulting firm and was a co-founder of H Robotics. Pippa received the MS in International Relations (1986) and a PhD (1991) from the London School of Economics.
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Curmudgeon Notes:

1. A February 18^th NY Times article echoed the idea of Fed control over the markets in the minutes of its January FOMC meeting:

Fed’s Chairwoman, Janet L. Yellen, suggested that investors had overreacted and could reverse themselves. “The large magnitude of changes in domestic financial market conditions was difficult to reconcile with incoming information on U.S. economic developments,” it said.

2. In a very provocative February 19^th Investor's Business Daily article, economist Robert Samuelson debunks Ms. Yellen's notion that “economic expansions (and bull markets) do not die of old age.” He wrote:

The quest for unending prosperity is doomed to fail. Indeed, it may backfire. Periodic recessions and bear markets perform a useful, if distasteful, function. They remind people of risk; they restrain inflation.

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Short Selling is a Dangerous Game:

With the above perspective in mind, being a MARKET short seller is very dangerous today because the US stock market is not a free market. Whatever the Fed controls, it will do to its liking.

As we've repeatedly noted, the Fed “talks the talk” to prop up falling markets. In particular, the NY Fed's Bill Dudley seems to time his speeches that suggest a QE 4, 5 or 6 when the stock market is falling steeply, so as to save those long the market. We also believe the Fed uses surrogates – like its dealer banks and foreign central banks – to buy stock index futures and index ETFs whenever the market is in danger of breaking critical support or is approaching the bear market definition of “20% decline from the highs” as on October 3, 2011.

To make money on the short side you need to be a market trader who is very fast, or a fundamental stock short seller, who is an investor. Today, individual traders compete with HFTs² and computer based algorithmic trades which are executed at lightning speed.

Note 2. Critically important: HFT amounts to legalized "front-running."

Curmudgeon Note: The “fundamentals based” short seller (which selects individual stocks to short based on fundamentals, rather than technical market analysis) is subject to many risks. Among them are momentum traders going long the stocks they've shorted and those stocks being acquired or taken private. Many well-known long/short equity hedge funds had their shorts go against them in a big way in 2015. For example, David Einhorn's Greenlight Capital bet against some of the best performers of 2015, including Netflix Inc. which returned a whopping 134% in 2015 and Amazon Inc., which racked up an 118% gain last year, according to FactSet data.

A Very Different Environment in Past Decades:

In the early 1970's in 1973 and 1974 the Fed never used this kind of reckless power. In addition, being a big market short seller was easy at the time. The fundamentals of the markets were not CONTROLLABLE; therefore, short selling was very profitable.

· In 1973 OPEC instituted an oil embargo on the US, and the S&P 500 declined -14.66%.

· In 1974 we had a Constitutional Crises when President Richard Nixon covered up a political burglary of the Democratic headquarters, i.e. a conspiracy to cover up a felony. The S&P 500 declined -26.46%. Small Caps were -30.9% and -19.95% respectively.

[Data from IBBOTSON ASSOCIATES - now owned by Morningstar]

The financial markets were a great trading environment in the 1970's, because there was no Fed interference. From the early 1970's through-out the mid 1990's, Fed Officials NEVER made speeches on policy or expressed their thoughts on interest rates and the economy. They do that all the time now!

How times have changed! Unless you're an individual "stock" short seller, it's been extremely difficult to make money trading short, because of the “Fed Put³.”

Note 3: The “Fed put” actually started during Alan's Greenspan's reign as Fed Chairman when it was known as the “Greenspan Put.” The basic concept is that the Fed will “bail out” the markets with its policy adjustments (e.g. lower interest rates, ZIRP and QE). That's the equivalent of an invisible “put” which places a floor under the stock market and hence protects those that are long stocks.

In a speech at the Cato Institute, Washington, D.C., on November 30, 2007 titled “Market Bailouts and the Fed Put.” St. Louis Fed President (and voting member of the FOMC) William Poole acknowledged that the “Fed Put” exists, but stated that (historically) the Fed had not bailed out the stock market. Of course that was before, the Fed's unconventional and extraordinary monetary policies used after the 2008 financial crisis.

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Conclusions:

1. Curmudgeon: My view on the difficulty of short selling (and short term trading in general) is summarized by two sentences in the February 16^th Chartist Mutual Fund hotline. Dan Sullivan wrote (emphasis added):

“Day to day volatility has certainly increased which can be directly attributed to the continuation of zero interest rate policies and now negative interest rate policies across the globe. The central banks have created a casino like atmosphere, as stocks, oil, bonds and precious metals swing wildly on a day to day basis.”

2. Victor: The Fed mentality is best described by an anecdote in the great movie titled: “The Good, the Bad, and the Ugly."

Mexican bandit Tuco Ramirez says to Corporal Wallace:

"I like big fat men like you. When they fall they make more noise. And sometimes they don't get up."

In my view, the Fed is committing financial suicide with their reckless monetary policies, yet they don't know it. When the big-one happens, the Fed won't be able to get back up. They will surely be blamed and leading members ousted.

Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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