Thinking Of Shorting The Market? Read This First

March 14, 2018

Thinking Of Shorting The Market? Read This First

  • Shorting isn’t for everyone, but if done smartly can offer positive risk reward opportunities and great hedges.
  • It looks like we’re ready for a big drop.


In today’s article, I’ll discuss where we can find fragilities that would offer attractive short opportunities from a macro perspective. An article on where to find short opportunities on the micro perspective with examples will follow, and also an article that will explain how shorting isn’t for most people.

We are now in a ‘pre-bubble’ state that could quickly turn into a bubble and, consequently, there is a 70% chance for a U.S. recession by 2020 according to Ray Dalio, the founder of the biggest hedge fund in the world, Bridgewater. This means we have to start looking for short opportunities.

We have had a certain economic environment for quite a while with declining interest rates, low inflation, declining commodity prices, and relatively stable economic growth. When such an environment lasts for a while, corporations get accustomed to that and some of them might not be ready to adjust to the new environment.

The new environment is one of extremely positive economic news, like the last jobs report in the U.S. which blew past estimates which will prompt the FED to keep steady on the path of increasing rates and the ECB to stop buying bonds. So we will go from a rigged market to a hopefully normalized market where those who have been surviving just thanks to low interest rates and money printing will get into trouble.

These are the points one should look for when analyzing short candidates:

#1: Debt Burdens Will Increase Due To Higher Interest Rates

The key to valuations and stock market prices are earnings. If a company has a lot of debt and higher interest rates lead to increased costs, earnings can be impacted and, consequently, we would see a lower stock price with all that follows on Wall Street – downgrades, refinancing issues, fire asset sales, etc.

#2: Unemployment Is At Maximum Levels

When the unemployment rate is at 4%, it simply means that there are few possibilities to find new employees without significantly raising the costs of doing so. Further, you also might not find enough quality for what is necessary and thus this might also dampen growth.

Figure 1: Unemployment in the U.S. Source: FRED.

#3: Higher Commodity Prices

If a company is dependent on higher commodity prices, this will reflect on earnings, especially this year’s earnings as most companies use the FIFO (first in – first out) accounting method. Therefore, it takes a while for a strong commodity market to be seen on the income statement.

Figure 2: Bloomberg commodity index in the last 12 months. Source: Bloomberg.

#4: Unfavorable Business Conditions

At some point, this debt driven economy will be unable to expand more but that is something that will happen after the bubble, thus we have a bit more time to focus on that as unfavorable business conditions will push the whole market down and not just certain stocks. However, when it comes to shorting, timing is everything and for now it looks like the economy as a whole is going to dance a little bit more. Therefore, it’s important to find pre-bust, or better to say, bubble fragilities among stocks.

#5: Counterparty Risk

Most of the asset prices we see are formed by credit. If a house is financed with a 20% down payment and an 80% mortgage, it might look like the value of the house is X, but it actually isn’t. The real value of the house is not known, the credit value is. As long as there is available credit and demand, the price of the house will do fine but when one of those factors disappears, the paper value also quickly vanishes.

Figure 3: Mortgage debt levels are close to 2008 levels again. Source: FRED.

Now, the debt piled up in the last few years was taken at an interest rate mostly below 4% while the debt taken in the 2000s was mostly above 6%. That’s a huge difference in how buying a house is approached.

#6: How Big Is The Exit Door?

Recently, I was reading Nassim Taleb’s last book—Skin in the Game—and I found a very interesting commentary about the markets. His point was that it isn’t so important how big the market is, what’s important is how big the exit door is. In theaters, when somebody yells fire, all that matters is how big the exit door is. Similarly, in markets, when the next crash comes, all that matters is how big the exit door will be.

In January 2008, a $75 billion forced sale by Societe Generale pushed European markets down 10% in one day. So the global market might seem big with its $90 trillion market cap, but the question in a crash is always how big the exit door is. The point is that in a crash, that door is usually very small.

I’m going to continue this series by looking at micro short indicators and at the dangers of going short so that you can see if shorting is something for you.