Quarterly Commentary

My tenth issue of Piranha Soup continues the theme of the ninth version. It was focused on rough times in fixed income, particularly credit derivatives. Now I turn to rough times in equities with an emphasis on whether it is time to enter the short side of the stock market. The madness of crowding into the "credit, energy, Asia, emerging markets" growth story will reach a point of froth this winter. Below I make a case for profit in short side beta and alpha.

Many will ask why I would focus on shorting stocks when they are not expensive and in fact are fair value relative to bonds. Economic growth seems strong and on balance earnings are holding up while the world is in pretty good shape. I am adding shorts because there is strong evidence that short side alpha has bottomed, meaning it will become easier to pick losers among companies. As hedge funds, we are charging investors to play two sides of the market and so, if alpha is available, we are supposed to go after it. Underlying this, I am bearish on US stocks claiming that the corollary to 2002 will hit this winter. Earnings are about to break down. I believe those funds that implement good shorting methods will be those that have the buying power in the next great bull market.

Section One: Why Short the Markets Now?

One of the worst strategies in the hedge fund arena for the past 15 years has been shorting companies indiscriminately as a hedge. Those with a jihad against the market due to fear are never rewarded. Also, recent statistics show high levels of short interest. For short sellers, the cost of borrowing is expensive. Below I make a case for why factors are now lining up to overwhelm the bulls. I examine earnings, interest rates, the housing bubble, and liquidity. The analysis is largely a US analysis since shorting is difficult outside the US and since it is the US that is rolling over. I have adjusted the charts and analysis to give a different view than seen in most economic reports.

1. If the market's PE is not overly expensive, then I must make a case for earnings to break. Let's start with the simple fact that earnings make equity prices tick. Earnings can be broadly predicted by input costs such as energy and credit and by output demand. This is a function of how competitive the exchange rate is and by the economic health of the buyer. I have addressed credit cost as a whole section below. Enough has already been written about energy input costs but let me summarise that in fact energy is not the factor that it once was. It does not need to be. It is making a negative contribution on the cost side to a picture that is already deteriorating on the demand side.

   Turning now to demand, our central focus is a US consumer that is stretched and many technical indicators that show this cannot continue much longer. While others have focused on spending for energy and interest as a percent of disposable income, I choose to focus on how long the consumer can take the pain of overspending. The chart below shows that for the first time in over 45 years, both consumer services spending and consumer non-durable goods spending are up as a percent of disposable income. There is for the first time a positive correlation for eight quarters. The US consumer is spending on everything and of course the source of this is his credit cards and/or his second mortgage on his house and/or reducing savings. I will start with savings to determine how long he can borrow from himself before he must slow down spending.

   Consumer Spending as % of Personal Disposable Income
   

   Source: BEA/Wolf International

   The US consumer has tapped into his savings like never before and this is well known. What is less well known is that the savings rate in relation to the short-term interest rate is also at extreme levels. The incentive is to save but the consumer is not saving due to the wealth effect of a housing bubble and ready access to credit via bad lending practices in housing. Below is a compelling chart showing the 1-year treasury yield minus the personal savings rate. The chart measures the 2-year percent change and therefore captures the recent shift in interest rates. The point of the chart is that I can look all the way back to the 70's and still not find a time when consumers chose to have so little savings with interest rates rising this much this fast. Why does a consumer borrow in the 00's when he did not borrow in the real estate boom of the 1970's? We know the answer is sloppy credit.

   Yield on 1-Year Treasury Minus Personal Savings Rate: 2-Year % Change
   

   Source: Federal Reserve/BEA/Wolf International

   This leads us to our next question, when is the credit going to be taken away. Starting with credit cards, the new bankruptcy act in the US is requiring higher minimum payments on credit cards beginning 1 January 1 2006. Some banks have already imposed these higher payments. There is a doubling of the minimum. Our math suggests this is not an overwhelming burden, but it is another log on an already burning fire. If my savings are negative and my credit cards are not available, that leaves my house as a source of credit. The turning point in the market is therefore a function of the removal of sloppy credit practices in housing. It is no wonder the Federal Reserve is focused on this and is ratcheting rates to cool it down.

   The impact of a roll over in housing is much greater than it appears on the surface. Not only is it the main source of debt growth, but employment in the housing sector is way above trend. One of my favourite managers tells me 3.7 million jobs will be lost if the housing market reverts to the mean uptrend. The losses are about equal in construction and mortgage lending. This does not account for the risk of a burst in the bubble that moves those jobs below the long-term trend. The housing market in the US has now turned lower in critical markets. Housing prices are falling in some areas. Housing prices do not need to fall everywhere to cause concern. They simply have to stop going up so much that they are a source of credit. This process has now begun.
   
   

2. If stocks are fair value relative to bonds, then I must make a case for bonds to break. Most central banks are now raising rates or are threatening to. Rates may not go up much more globally but they are going up and not down. My readers will also recall that several issues of the Sopa have stated we all pay too much attention to central banks and not enough attention to the interest rates of real companies. Credit spreads are still tight but have broken their downtrend. Volatility has also shown signs of bottoming. This normally coincides with the bottom in default rates. All signs point to higher costs ahead for credit and the attending unwind of leveraged plays on credit. The interest rate sensitive parts of the US economy have begun to roll over. All of this signals us to lower risk. See the 9th issue of Sopa for more details.
   
   

3. What about left tail risk? Prior issues of Sopa have shown how correlations are rising using a cross correlation heat map (below). Even with economic decoupling we are seeing high correlations among markets. The evidence also shows that correlation among hedge fund strategies is the hottest it has ever been. On the next page I show the cross correlation of hedge fund strategies. It is important to note how correlations have risen through time. The current heat map shows every strategy with abnormally high "coherence". See the 7th issue of Sopa for details on coherence. At the present time coherence is higher than in the summer of 1998.
   

   Cross Correlation Heat Map: Aug 91 - Jul 93 Source: HFR/Wolf International Cross Correlation Heat Map: Feb 01 - Jan 03 Source: HFR/Wolf International Cross Correlation Heat Map: Oct 03 - Sep 05 Source: HFR/Wolf International

   Risk levels are very high for hedge funds now because things are so good. The market never rolls over when things are bad. It peaks as the good times peak. All of my indicators suggest this is soon. The timing of this is very hard to predict. Bottoms are easy to find, everyone is in a state of panic. The best guess time frame for a significant top in the market is this winter (December to March).

Section Two: How Has the Market Changed for Shorting?

If we are going to contemplate shorts, we are forced to notice the changing dynamics of the shorts side. There is a reason some hedge funds are moving to long only. The structure of the market has undergone monumental change since the last time I wanted to be short. To summarise, transaction costs are down, the markets are more fragmented and speed of execution has risen. This sounds good except that the "tails" in small companies are full of crowded shorts. Below I look at the changes in some detail.

1. What are the changes specific to equity trading in the last five years? There are more short sellers than ever. Below I show the absolute level of shorts just in specific NASDAQ equities. This does not of course include exchange traded mutual funds (ETFs) and other shorting methods. While the absolute amount of shorts has tripled in ten years, the totals are still tiny. There is no evidence that there are too many shorts or too much short interest overall.

   In addition to more shorts, the market is increasingly fragmented. In 1997, the SEC began to permit equity trading in alternative trading systems (ATS). The result was the electronic communication network (ECN). Market makers were cut out and today over 50% of trading in NASDAQ listed stocks is done "off exchange". This caused margins to collapse and some chaos ensued. More recently the market created what is effectively a consolidated limit order book (CLOB) to consolidate all trading information in one place. By 2001, decimalisation was also introduced further reducing the cost of a trade.

   Since the size of the quotes was reduced, liquidity for institutional investors at the quoted level was also reduced. For those so inclined, it also became cheaper to step in front of big orders and to meet up tick rules. The outcome of all of these changes was a need to feed orders in smaller blocks through all available liquidity sources. This vicious cycle led to a drop in the average trade size from 1500 shares to 300 shares in five years. The next shoe to drop is the elimination of the up tick rules which is already being tested.

   In June of 2006, regulation NMS is planned. This makes it illegal to execute a trade at a worse price than is available elsewhere. This will force a reconsolidation and instantaneous communication. The bottom line is that exchanges are going electronic and we all will have the same execution and information. Clearly this process has taken away the easy edge of professional shorting. Hedge funds are now forced to do original work and find bad companies. One might also conclude there are more opportunities for shorting in other countries.

   Dollar Weighted NASDAQ Short Interest as of % of Dollar Shares Outstanding
   

   Source: Wolf International/NASDAQ
   
   

2. A second major market change is that short sellers are using more indices and ETFs. Simply put, hedge funds are hedging and not shorting companies. This explains why short side studies in hedge funds suggest the alpha is negative. It is a pure cost. Shorts in ETFs now represent as much as 50-75% of trading in some markets. The amount of shorting has tripled in recent years in ETFs. This heavy shorting of indices also explains why index volatility is less than individual stock volatility. Heavy two-way trading in these indices is compressing market movements, at least for now.

   NASDAQ Composite: Historic Cumulative Dollar Short Interest as Fraction of Total
   
   

   Source: Wolf International/NASDAQ

   The chart above shows the shorting of the top 100 NASDAQ stocks since 1994. It measures the cumulative dollar short as a percent of the total to show how large stocks are being shorted versus small stocks. It shows that shorting in the smaller stocks as a percent of the total is rising far more than in the larger stocks. This is what you would expect with index shorting of a cap weighted index. Short sellers are now shorting all stocks and the smaller ones are being shorted more as a percent of total shorts. The cost of borrowing these stocks has gotten expensive.

3. A third market change is that short side attribution is negative even for those hedge funds that are trying to select bad companies. This is almost certainly due to crowding. As I researched this Sopa, I spoke to many funds about their shorting. These were both short sellers and long/short funds. Many complained of negative attribution. We were able to get (though not publish) information showing that some of the world's best managers make more than 100% of their short side gains on companies that go near zero. What seems clear is that shorting stocks to make money from lower prices is a losing game even if beta is excluded. The managers that make money locate companies that are going to implode so that the stocks approach zero.

   Below I show this graphically. The NASDAQ is once again used but this time with all members of the composite. The colours show the percentage of short interest in those stocks. The small ones are clearly being heavily shorted and increasingly so since 1994. There were few shorts in these stocks until 2003 and now many of them have more than 20% short interest. It is no wonder they are hard to borrow. Small companies are more likely to go broke and so it is expected that the shorts are concentrated there. Those funds doing original work are finding the right shorts and not the crowded shorts being touted by the street.

   NASDAQ Composite: Stock Specific Short Interest Percentage
   
   

   At the beginning of this Sopa, I mentioned that short side alpha was going to improve. In fact it has improved since late 2003 when alpha was at its negative peak. During 2003 bad companies moved higher in sympathy with the general trend. More particularly, high earnings leverage at that time meant any economic improvement fell to the bottom line. In the 4th issue of the Sopa, I focused on improving equity alpha from four sources. These were normal volatility, stable economic indicators, geographic decoupling, and individual market/equity dispersion. In fact volatility fell from abnormal highs to its abnormal lows. Now, as default rates rise, volatility will pick up again and we will see more alpha. Economic indicators did stabilise and we are now seeing geographic decoupling. Recently I am just beginning to see evidence of individual equity cluster volatility, as shown on the chart below. This is possibly the signal I have been waiting for to see improving equity trading markets again. It certainly will help statistical arbitrage and so my next Sopa will focus on statistical arbitrage.

Cluster Volatility in Annualised %

In section two I have shown how the market has changed on the short side. Clearly the opportunities have changed and those that understand the opportunities are making money shorting.

Conclusion

Short selling is a beta game for most of the hedge fund industry now. Since few managers claim to have any beta edge, we must ask what we are paying for. As a fund of funds that does make beta-driven adjustments to our portfolio, it is time to use shorting to get more neutral. We have also been careful to look for alpha and we are finding it though it is as rare as new copper mines these days.

Good luck in your investing and we hope you enjoyed your piranha soup…

Sopa Piranha was originally published by Wolf International, 31 October 2005.