The Reddit forum WallStreetBets on a smartphone arranged in Sydney, Australia, on Thursday, Jan. 28, 2021.
Brent Lewin/BloombergIt was bad for the short sellers. Now it’s worse.
Dedicated short-selling funds were down an average of 48% in 2020, after losing 22% the year before, according to Chicago-based Hedge Fund Research. Just as the survivors were licking their wounds in January, they got overrun by a human wave of retail traders swarming anything with sizable short interest, from GameStop (ticker: GME) to Macy’s (M).
Mitch Rubin is glad he exited the small-cap short positions held by his RiverPark Long/Short Opportunity Fund (RLSFX) last year. “This is a unique period of time, where shorting is more dangerous than usual,” he says. The $450 million mutual fund was up 55% last year, because Rubin avoids the heavily-shorted names popular among short-selling hedge funds. “Those stocks are like picking up nickels in front of a bulldozer,” says Rubin. “If they’re hard to pick up, you should know to run.”
“People are blowing up left and right,” said a hedge-fund manager about his peers on Wednesday. “I don’t know if I want to keep playing. The rules have changed and I’ve lost more money than I can count, trying to invest by doing stock analysis.”
No one mourns a short-seller’s losses, he concedes. Shorting has been unpopular since it emerged not long after the Dutch invented stock markets in 1602. A short play is designed to take advantage of a falling stock. You borrow shares from a long-term holder, then immediately sell them for cash. If you’re right and the stock falls, you can use some of the cash to “cover,” that is, buy back the shares at a now-lower price and return them to the lender, with the remaining cash as profit.
But if the stock rises while your short position is open, you can get squeezed. The broker who arranged the stock loan will demand that you put up more cash, as collateral to ensure you’ll be able to buy stock when closing out the short. If you don’t want to maintain the bet, either you or the broker will cover the losing short position by buying stock at the higher price. Your forced buying may push the stock higher still, which is why rival traders sometimes try to arrange short squeezes.
Short seller Marc Cohodes rode out many a squeeze before shuttering his Copper River Partners hedge fund during the 2008 financial crisis. He sheds no tears for shorts getting blown up now. No one should feel sorry for money managers who have been taking 20% of their investors’ profits and buying sports teams, he says.
“There are too many hedge funds who use too much leverage who are all in the same names,” grumbles Cohodes. “The Reddit crowd pulled a French Revolution on these clowns.”
Kurt Feshbach ran a billion dollars in one of the first big short funds back in the 1980s, with his brothers and investor Tom Barton. Today he just does investment research, but he recalls earlier episodes of short squeezing. In the 1990s, they were organized on a small scale by the penny stock broker Ray Dirks, who targeted short sellers in the name of his ShortBusters Club. Another wave arrived with the dot-com bubble. Today is different, says Feshbach, with social media and discount brokers enabling masses of small traders to overwhelm sophisticated funds like Melvin Capital.
Past attacks on shorting were countered with pious sermons about how shorts help rein-in market bubbles. If no one is crying for today’s shorts, says Feshbach, there should at least be concern over how it will end for individual investors. Thursday’s vertiginous drop in GameStop showed how prices can collapse in a short squeeze when the buying stops.
“When Melvin Capital and the rest have been forced to cover ... who’s left to buy these stocks?” Feshbach asks. “After the short squeeze, eventually you have a long squeeze.”
Stock exchanges and the Securities and Exchange Commission created circuit-breakers to halt the havoc of plunging stocks, but dangerous blowoffs on the upside have gotten less attention, says one hedge-fund manager.
“It’s the regulators’ job to protect them, not me.” says the fund manager. Trading restrictions imposed by online brokers in some short-squeeze names were just ad hoc responses. Without regulatory safeguards, he warns, Reddit traders will eventually come to grief.
Hedge-fund investors were patient last year if their managers lost money on shorts, because everyone was making so much money on the long side. The latest squeeze may exhaust their patience—especially with long-short managers whose shorts are blowing up and whose longs are underperforming value stocks.
Of course, if some hedge funds die out after the Reddit squeeze, others will arise to take their place. “This is a fire that will clear the forest,” says Cohodes. “Up-and-comers and sharp people will show up to do the job.”
Write to Bill Alpert at william.alpert@barrons.com
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