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Kass: In Defense of Short Selling

This column originally appeared on Real Money Pro at 8:36 a.m. EDT on Oct. 8.

NEW YORK (Real Money) -- With what seems to be under the guise of sound twenty-first century central banking, the Fed's policy of providing ever more easing through the manipulation of interest rates and even possibly aiming at raising asset prices (such as equities), I continue to hear the following objections from many investors and traders:

  • Why bother selling short?
  • Isn't short selling a mug's game?

Over the years, in search of a variant view, my analysis has often led me to reject general expectations and orthodoxy. At times, this has put me at odds with consensus, as I am sometimes bullish when others are bearish and bearish when others are bullish.

Sometimes I get it right -- sometimes I get it wrong.

Markets are invariably moved by the unexpected or what the crowd is not anticipating, particularly at inflection points. Part of my job (as I see it) is to game whether the crowd is correct of view or wrong (and should be faded). Legendary hedge fund manager Michael Steinhardt once said that developing a variant view is what puts distance between ordinary and superior investment performance.

As we all know, the objective of establishing a profitable, non-consensus view is easy to talk about but hard to isolate in analysis and put into practice. Since the crowd is more typically optimistic, 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's research departments and are usually confirmed by management, which is not true of shorts.

I couldn't disagree more. Financial concepts have their seasons, and the market's numerous dives over the past decade combined with the uniqueness of today's structural worldwide economic challenges and the increased frequency of black swan events suggest that, when timed properly, a great deal of money can be made on the short side.

Sometimes a market gets terribly overvalued -- as it did in the late 1990s, when investors adopted the notion that the DJIA was destined to reach 36,000 (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 created unique opportunities on the short side.

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