As we near the end of the third fiscal quarter of 2021, it is worth taking stock of the winners and losers of the year to date. With the stock market having shown little sign of losing steam all year, the losers on the long side have been hard to identify. For those who play on the short side, however, it has been another story altogether.
In the face of the seemingly relentless market frenzy of late, successful short bets have been few and far between. Indeed, even the most skilled of short sellers, such as Jim Chanos (Trades, Portfolio), have struggled.
Meme stock summer
Some of the biggest short seller losses of the year came in June, as heavily shorted “meme stocks” such as GameStop Corp. (GME, Financial) and AMC Entertainment Holdings Inc. (AMC, Financial) found themselves the subjects of monumental short squeezes orchestrated, in large part, by retail traders leveraging online message board platforms like Reddit to coordinate their actions.
I have discussed the impact of the so-called “infinite gamma squeeze” in these stocks, which has allowed a number of cash-burning companies to sell shares to pad their balance sheets, effectively at short sellers’ expense. Unsurprisingly, this turn of events has soured many investors on short strategies, an issued\ that was highlighted by Andrew Beer of Dynamic Beta Investments in late June:
“In two waves, a few hedge funds have seen modestly sized short positions turn into extinction-level events…[Hedge funds] will face difficult questions from investors as to whether their risk management failed to adapt to a changed market environment."
This issue has plagued even the most distinguished of short side hedge funds, including Chanos’ Kykinos Associates. The guru lamented the current state of the market in a June 25 interview:
“You’re seeing all kinds of situations now that probably wouldn’t pass muster in the IPO process that are coming public via the SPAC machinery. As the boom has gone on, we suspect that more and more companies are playing fast and loose with their projections in order to entice investors to commit capital...Life is rough on the short side. If I was a stripper pole company, but announced a merger, I think I could raise a lot more money than the short sellers are right now.”
According to Chanos, the market boom has turned into a speculative frenzy that has resulted in a lot of capital being allocated to frothy growth and story stocks. So much so, in fact, that they have become extremely dangerous to short––no matter how dislocated a company’s share price is from its fundamentals.
Consequently, many hedge funds known for emphasizing short-side strategies have suffered major outflows this year. Kykinos has not been immune; the hedge fund saw its assets under management slip to less than $1 billion––a far cry from the $7 billion it boasted in the fearful days following the great financial crisis. Even the $100 million windfall it secured in the wake of Wirecard’s collapse this summer failed to stem the bleeding.
Sympathy for the short seller
The changing of the seasons appeared to have done little to change the fortunes of Chanos and his fellow short sellers, at least at first––a state of affairs that had few market participants shedding any tears. That can hardly be considered surprising, as short sellers are rarely popular. Indeed, antipathy toward the practice has grown over the past few years, as I have discussed previously.
In the face of persistent market momentum, some short sellers have sought ways to adapt to the new normal. Rather than making big, concentrated bets, some funds have opted to take smaller positions in a larger number of names, while others have begun to target overbought indexes instead of individual stocks, or simply pared back their short side exposure altogether.
Not all short side hedge funds have lost faith in the strategy, however. Chanos, for one, is still in the game. Speaking to CNBC last month, he highlighted the dangers he sees building up for investors complacently riding the bull market wave:
“The problem with getting more people, retail, involved is that it always seems to happen toward the end of every cycle. Retail wasn’t there at ’09 at the bottom. They weren’t there in ’02 after the dot-com bubble collapsed. They were certainly there at ’99. So the problem in the last few cycles as I see it is that we get promoters and insiders and people who have done very well cashing out as retail is buying...If you get prices high enough, you are going to see lots and lots of equity issuance not only from companies that can put it to good use, but from all kinds of questionable business plans and outright scam. That’s sort of where we are now. We are getting into money being raised for all kinds of things that probably aren’t at the end of the day going to be productive but might line the pockets of the promoters doing it.”
My take
While Chanos has continued to bang the table about the rising frequency of substandard stock issuances in combination with questionable promotion schemes, regulatory bodies such as the Securities and Exchange Commission have shown little desire to curb them. Newly minted SEC Chair Gary Gensler, for example, made it clear during a Sept. 15 television interview with Jim Cramer that he has no intention of targeting the sorts of aggressive stock promoters bemoaned by Chanos:
“Before we had television, people did it on the radio, now we have various social media platforms. That’s not only free speech, but it’s part of what makes our capital markets robust, that people can disagree and disagree using the media of the day. But I also think we do police the markets for fraud, manipulation, for pump-and-dump schemes and the like.”
Given the current regulatory environment and market dynamics, the short side is a distressingly dangerous place to be. Even the rout in AMC stock that began in mid-September, which has seen short sellers gain back more than $1 billion, does not necessarily signify a general reversal in the fortunes of meme stocks.
I have a great deal of sympathy for short sellers, especially in the face of widespread irrational exuberance. However, I also believe that anyone taking the short side––even the most outrageously priced stocks––has rarely felt so dangerous.
