Short Selling

From Bill Fleckenstein, October 6, 2014

The purpose of this letter is to share my current thinking regarding the possibility that short selling may become a viable reality sooner than I had expected. Obviously, any thesis about what might change the course of financial markets is inherently speculative guess work. Nonetheless, it is an exercise that often proves worthwhile if one remains flexible enough to adapt and use new information in the formulation of a thesis.

When I closed the RTM Fund in March of 2009, I did so because the market had collapsed and, more importantly, I knew the Fed would print money in an attempt to reflate the economy and financial markets. At the time I didn't think they would be too successful with the economy, but felt they had a good chance to boost financial markets, and I was 100% certain that short selling would not be a viable way to make money. (I never dreamed the Fed would ultimately print $3.6 trillion and triple the stock market, but it has.) I also felt the Fed would be able to do whatever it wanted from a policy standpoint until such time that it had printed so much money that it lost control of the bond market. I dubbed that outcome "the bond market taking away the printing press." As you can imagine, if the Fed were unable to paper over financial problems via debt monetization, the financial markets (and economy) would have a very serious case of "withdrawal." In that environment, making serious money on the short side would be far easier than it has been for over 20 years.

It was the prospect of the bond market doing just that, when 10-year bond yields backed up to 3.0% in the fourth quarter of 2013, which caused me to prepare to launch the RTM 2.0 fund. However, it soon became apparent that the rise in rates was just market noise surrounding the Fed's intention to begin tapering its money printing. Thus, I realized the launching of RTM 2.0 (or more precisely, actual short selling) would need to be postponed indefinitely.

Early last summer, I subsequently sent a letter to those who had expressed an interest stating that short selling would have to remain on hold, as my "checklist" (for an environment where risk is manageable and short sales are profitable) still said "don't be short."

For me, the most important ingredient for successful short selling, in the activist-central-bank era we find ourselves in, is a loss of confident in the Fed. While the bond market taking away the printing press scenario, which I noted above, was my best guess at what would create such an environment, I knew there were other possible ways that psychology could change, but that scenario seemed the most likely way such a shift might come about.

The scenario I had in mind to precipitate such a change revolved around the stock market cracking as the Fed tried to taper, which would lead to a resumption of QE and a subsequent negative bond market reaction. That outcome is still possible, but I have formulated a new thesis that suggests that a loss of confidence could evolve sooner. This new idea (though a variation of my original idea) is predicated on my view that the only reason financial markets are where they are is because the Fed printed $1.5 trillion in the last 18 months (on top of the roughly $2 trillion they had printed in the prior three years). Therefore, a cessation of QE3 should result in a market decline, just as occurred when QE1 and QE2 were phased out, only bigger.

More importantly, the fact that markets have risen as QE has been tapered, while expectations have become very elevated for the economy and stock market, combined with various signs in different asset classes of intense speculation, has led me to think that a serious stock market dislocation could now cause the loss of confidence so crucial to success when selling short in the modern activist central bank era.

Why do I feel this way now? After giving the subject a tremendous amount of thought, I now see the current environment as a mania similar to the stock mania that cracked in early 2000 and the real estate mania that collapsed in 2008. (I was correctly able to identify them in advance and capitalized when they collapsed.) Up until recently, I didn't really see a bubble that would be obvious to spot when it imploded, one that would take confidence and the economy with it. However, I have realized that part of my not seeing another mania was a function of how I (and others) define subjective financial events, i.e., bubbles, manias, etc. (Basically, I had potentially been lulled to sleep by my own definitions, which I made up to begin with.)

w5000 index

Also, I had assumed (for no good reason) that if we were in the middle of the third bubble/mania in 15 years, it needed to be in an asset class different from the prior two. Government bonds are an obvious choice, as they have been an enormous beneficiary of global central bank money printing, but the behavior in the bond market hasn't really fit my working definition of a mania. The reason that understanding this matters is because I believe that when manias collapse, confidence in the central banks is lost for some time, which, as I have noted, is the driver for successful short selling.

The fact of the matter is that if I tweak my (subjective) terms and definitions to some degree, I can make a pretty good case that we have been in another stock market mania, and thus if the market suffers a very serious decline (with the attendant problems in credit), which I think is a virtual guarantee at some point in the coming 12 months (but probably sooner), confidence in the Fed's ability to deliver a self-sustaining recovery and higher stock prices will be lost.

So let me walk you through those past manias and try to put the current environment in perspective. If we define a bubble as the epicenter of the misallocation of capital caused by overly loose central bank polices (a definition appropriate for the era we are now in, which began with Greenspan), and a mania as the outward manifestation of that bubble, we will see that they don't have to be exactly the same.

In the late 1990s stock bubble, the misallocation of capital and the mania were both centered on the stock market, as millions (who shouldn't have) day traded, and silly business plans masquerading as businesses were able to garner monstrous valuations, and so on. In the leveraged, structured credit bubble, the mania was in real estate. That was the asset market where really reckless behavior was on display, but it was only possible as a consequence of the total lunacy occurring in the credit markets. In both those cases, when the mania exhausted itself, that market collapsed and took most other assets, the economy, and confidence in the Fed with it. If that was what you expected to happen (as I did), then it made it easier to decide when it was going to be safe to really short heavily. In the current environment the epicenter of misallocated capital (i.e., the bubble) has been in government bonds, but there has certainly been no manic behavior in that asset class (ex maybe some bond bulls, who may be over-leveraged). However, since virtually all financial markets in some way are priced off government yields, if those yields have been artificially depressed (which they have) due to central bank money printing, then everything else is likely mispriced as well.

The fact of the matter is that present valuations (highest market cap to GDP ever, ex late 1999/early 2000 and highest S&P500 price-to-sales ever), tight credit spreads regardless of credit quality, venture valuations, ridiculous IPOs, and inflated expectations of all sorts, are all suggestive of a mania. It is only the lack of participation by the public (which has been badly hurt by the two prior manias) that keeps this mania from being quite so obvious!

If that analysis is correct, then a stock market rout will lead to a direct loss of confidence and we might go through an extended period where Fed actions become irrelevant (except for the volatility that they will certainly trigger), as was the case from 2000-20002 and from late 2007-2008. Up until recently I have felt that a nasty stock market spill would "merely" lead to QE4 and that the loss of confidence would develop after that failed. That may still be the case, but I am just not so sure any more.

So the big question is, when does a central-bank-inspired (via money printing) financial mania end? My answer is, when there isn't enough money (credit) to keep all prices and markets levitated, markets exhaust themselves and begin to decline. That could happen at any time now, though "when" is never knowable in advance and can only be recognized as it occurs (assuming you have the right mental framework). That exhaustion is most likely a consequence of the growth in the size of inflated markets and a diminution of the prior easy money. It seems that the most extreme or weakest market niche breaks first. In 2000 the decline was lead by dot.coms, in 2007 it was initially the collapse of subprime credit, which began not long after first-payment defaults erupted in early 2007. Perhaps in 2014, it will turn out that the break in the Russell 2000 was the leading indicator.

Those implosions also followed, after long lags, tightening by the Fed. Today, the Fed is only talking about tightening and may never actually do it, but when the markets have to finally deal with the loss of that $1.5 trillion that has supported them the last 18 months, the effect will be the same as actually tightening. No one on earth has any idea what the lag time from the start of tapering to a financial accident might be, especially since the amount has been so immense. (For comparison purposes, the Y2K liquidity injection of December 1999, which blew the top off of the Nasdaq and led to the exhaustion of March, 2000, was only about $40 billion dollars, or just about two weeks' worth of QE3 monetization.) The bottom line is that we have wildly speculative markets underpinned by massive money printed that is ending, which is taking place at a time when both the domestic and world economies are sluggish at best. You could hardly have created an inflection point more conducive to a mind-altering stock market crash if you had tried.

Obviously, for any of the foregoing to matter there needs to be some stock market weakness. And while we have seen some deterioration in the Russell 2000 (and credit spreads) recently, the broader market has held up extremely well. It has only been in the last few weeks that it has acted even the slightest bit suspiciously, but experience has taught me that apparent stability can turn into chaos very quickly when the environment is as pregnant as this one is.

My plan at this juncture is to see if market weakness starts to develop in the fourth quarter and try to capture as much as possible, while still managing risk very tightly, until such time as it is clear that we are in an environment that will feed on itself and render the Fed less omnipotent in the minds of investors. If that develops, we will have an investible short-selling environment, which is exactly what I have been waiting almost six years for. If the environment doesn't get that dire, and the Fed can save the day for a while again via QE4, then I will have to go back to waiting for another setup. But what I don't want to do is miss an enormous opportunity just because it developed earlier and differently from what was nothing more than an educated guess to begin with.

In summary, the "loss of confidence in the Fed" trade that I have been waiting for since I closed my last short selling fund might be developing.