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In Defense of Short Selling

Stock quotes in this article: BRK.A, BRK.B

This column originally appeared on Real Money Pro at 8:02 a.m. EDT on April 2.

NEW YORK ( Real Money) --

What passes for sound doctrine in twenty-first-century central banking -- so-called financial repression, interest-rate manipulation, stock-price levitation and money printing under the frosted-glass term "quantitative easing" -- presents us at Grant's with a nearly endless supply of good copy.

-- Jim Grant

With the S&P 500 advancing by nearly 27% since the October bottom, it seems almost silly to defend the role of short selling, but I will do just that this morning. Over the years, I have rejected consensus and orthodoxy in favor of the logic of argument and power of dissection. At times, this approach puts me at odds with consensus, as I am often bullish when others are bearish and bearish when others are bullish, since the keystone to my market views is that there is little permanent truth in the markets. Sometimes I get it right -- sometimes wrong.

Markets are invariably moved by the unexpected or what the crowd is not anticipating. Part of my job, as I see it, is to game whether the crowd is wrong or should be faded -- or as legendary hedge fund manager Michael Steinhardt once said, to develop a variant view. As we all know, this objective is easy to talk about, but hard to put into practice. Over the course of time, this pursuit has led me to specialize in selling short, and at times I have maintained sizeable short positions (even as stock markets advanced).

It appears the basic objections to short selling are that:

  • when economies stumble, public policy (fiscal and monetary) comes to the fore and defends against an acceleration of economic and corporate profit weakness and often inhibits natural price discovery;
  • risk and reward are asymmetric in short selling;
  • the historic average annual positive return for equities is an insurmountable headwind; and
  • the exercise of selling short is analytically time-consuming -- long ideas are dished out on a silver platter by Wall Street, not true of shorts.

I couldn't disagree more. Financial concepts have their seasons, and the market's numerous dives over the past decade suggest, once again, that a great deal of money can be made on the short side and that we should revisit the case for short selling. Sometimes a market gets terribly overvalued -- as it did in the late 1990s, when investors adopted the DJIA 36,000 notion (i.e., that there shouldn't be a risk premium on stocks) or embraced the notion of a new paradigm (i.e., an uninterrupted economic boom) -- which creates a generational opportunity on the short side.

Other times (more often than the above condition) individual securities or sectors are embraced by market participants and levitated to unimaginable valuations, which also creates an opportunity on the short side.

Mainly, it seems to me that opportunities to challenge biases are much more pronounced and more easily identifiable on the short side, no matter what the market conditions are. If for no other reason, this is because so few are comfortable with the short side, which makes for an inefficient market.

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