Courtesy of Matt Sauer, MFSWNB Investments:

Populism has arrived at the door of the capital markets. Investment “mobs” are looking to Reddit to seek marching orders and take on the “elites” of Wall Street by driving up the price of stocks shorted by the hedge funds. As a losing short position becomes larger as it goes directionally the wrong way, it is much more painful to the investor than a declining long position.

At face value, short sellers are easy to dislike. Corporate management calls them anti-capitalists, long term owners find them disruptive and now the “mob” considers them “elites”. Are they not providing a functioning role in capital markets? Let us look.

Imagine there were two islands populated by investors. Pangloss Island has investors that believe that “this is the best of all possible worlds”. Their investment philosophy is to buy index funds as the world will increasingly be a better place.

Pangloss Island does not pick winners and losers of industry but magnanimously benefits from the arrival of new technologies for communicating, traveling and living. Inhabitants cherish new products yet invest knowing that they will capture the gains of capitalism over time with no effort. No one on the island has ever suffered long term disappointment in the financial markets as the main highway named Sub-martingale is a primrose path to success.

The other island Is Hobbes Island where the main philosophy is that “life is brutish and short”. This island believes that capitalism gives and the takes in cycles and in disruptions that need to be monitored closely. It is only through evaluation and observation that such a cycle can be avoided. Residents are always reminded of the glorious buggy whip company that was so loved but perished one day forever.

Hobbes Island has one road known as Martingale Way next to the river. Some days it is above water and other days it is below water, but it often cannot be a path to a desired destination.

There are two groups of investors on Hobbes Island: believers and non-believers. The first group accepts that life is brutish and short and believes that nothing can change it. The other group believes that life can be improved but change is necessary.

The non-believers want to see change today not tomorrow. The cycles and disruption must be tamed by substituting better products and new technologies. However, the non-believers realize that the believers will own investments that destroy capital and put the economy of the island at risk. They plead with the Panglossians not to allocate capital to companies destined for failure. However, the credo of “the best of all possible worlds” prevents the other island from listening.

Increasingly frustrated, the non-believers strike out on their own. Determined to see capital flow to worth investments and away from others, they create a fund. “Why should the losers continue to get our limited resources?” “Isn’t there a better way?”

The believers find the non-believers annoying and rush to tell those on Pangloss Island that they should be avoided. The leaders of the believers say that destruction of capital is necessary and does not need to be reined in. The believers conclude that the past is the best and it always works for the other island in aggregate so why shouldn’t it work in individual cases?

The answer lies on the roadway. Pangloss’ Sub-martingale roadway is a pathway to investment prices higher in the long-term future while the Hobbes road is not. The river rising and falling on the Martingale produces results that do not guarantee a higher price on an individual investment. The non-believers predict rain, the believers predict sunshine. Although it rains 70% of the time, the believers tell the Panglossians that the sun will come out tomorrow.

There is an old Wall Street saw that a rising market lifts all boats. However, that is only in the short term, in the long term most of the boats fail. When long investors see a rising market, they see sunshine while the short sellers see rain on the pathway. A rising river can be a dangerous place for investors.