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The short-selling world according to DARP

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Most market participants look at the short-side through their Long Only perspective. They believe that if they apply the same logic that has made their success on the long side to the short side, WorldAccording toGarpthen it should work. It should work but it does not. The Short side is still Terra Incognita, a vast continent populated with savage speculators. It obeys its own rules, its own dynamics. Newcomers to the world of short selling tend to be either too early or too late. Profitable shorts are at least as plentiful as long ideas. Market participants just don’t look for the right clues.
Stage 1: Contrarian shorts: from stratosphere to ionosphere
Market participants often come to short selling from the Long side. They believe in fairness. What is cheap should progress to fair valuation. Conversely, what is expensive should revert to fair valuation. Fairness is one of the very traits that transcends culture, race, and age. Toddlers have deep sense of fairness, long before they can speak. We are hardwired for fairness in a world that is not. Carrying that subconscious belief in the markets is a deadly virtue.
Market participants often see themselves as the lonely voice of reason amidst a delusional crowd. They may be right, eventually, but meanwhile  one single individual battling a mob is still an unfair fight. Stocks that have reached stratospheric valuations often have enough momentum to push to the ionosphere, before gravity reels them back in. Stocks on PE of of 100 have escaped the gravity of reason. They might as well go to 150, 200 or 3000. This is the rarefied atmosphere of permanently high plateau, paradigm change, because like before, “this time, it’s different”
Short selling something that does make sense does not make sense either. As Keynes used to say, markets can stay irrational longer than we can stay solvent.
From a portfolio construction perspective, this does not make sense either. On the long side, market participants expect fundamentals to improve and stocks to go up. They are in for the long haul. Meanwhile, on the short side, they expect imminent collapse. So, they are Long trend following and short mean reversion. Those have diametrically opposed reward to risk profiles. They have different P&L distributions and different sets of risks. Risks that are different do not cancel each other out but compound as they quickly realise. It is always painful to watch a short book accelerate faster than a dull long one.
Once market participants re-acquaint themselves with the old adage “the trend is your friend”, they are scarred enough to move to the next stage.
Stage 2: crowded shorts: the province of fundamental short sellers
The last 5% around the top and the bottom have claimed more market participants than the 90% in between.
When short selling by anticipation fails, market participants turn to shorting by confirmation. They wait for fundamentals and newsflow to deteriorate enough to place a trade. They have been scarred before, so they want every box ticked, every fact checked.
What they fail to realise is that if there is sufficient evidence to conclude that it is a short, there has probably been enough warning signs for long holders to bail for some time.
By the time short sellers have accumulated sufficient evidence to build a short case, long holders have left the building. Short sellers are left battling with one another over a dry bone. Those shorts  make sense, but they rarely make any money.
In fact, the reward to risk curve has inverted. Outcome is binary: either stocks goes to zero, either there is some corporate action: takeover, management change etc. One of my  London ex-colleagues used to say that a distressed stock going from 1 Euro to 50 cents is still a 50% decline. True: 1 to 0.50 is -50%, but only after 6 or 7 nasty short squeezes. The question is not whether stocks will get to zero, the question is will you still be there by then ?
In my time as a dedicated short seller, brokers used to call and pitch “structural shorts”. Structural shorts trigger a deep seated Pavlovian reflex: it makes me want to
  1. buy the stock
  2. graciously offer the borrow for free
  3. and send a box of chocolate to whomever wants to short. Chocolate  is a good therapy for smoothing the rough short squeezes ahead
Stage 3: Frustration and the despair of structural shorts
Contrarian shorts hurt. Fundamental shorts do not contribute much either. At this stage, market participants realise that the beliefs they hold about short selling may be right in theory, but still losing money in practice. Frustration and despair sets in. They have a couple of shorts and “hedge” their portfolios via futures. At that stage, market participants have literally no idea on what and how to sell short.
What happens when we lose your car keys in a dark corner of a parking lot? We go and look for them under a lamp post, where there is light of course. Market participants look for those structural shorts that will go down forever so that they can throw away the key and go back to their longs.
Market participants who publicly profess their hunt for structural shorts are unfit for managing people’s money for two reasons:
  1. Divorce from reality: Structural shorts are like market gurus: they are a dime a dozen. Profitable structural shorts are like market wizards, good luck finding one. Borrow is expensive and long holders have left the building a long time ago
  2. Abdication of responsibility: when they say they want structural shorts, what they mean is they do not want to be bothered with the short side anymore. They want to find something that they can throw in the short book and “forget about it”. This is an implicit acknowledgement of failure. They are happy to collect fees, but reluctant to do the work. There is obviously no hedge, no downside protection, no free lunch and eventually no happy ending.

At this stage, market participants resort to futures. They realise their vulnerability both versus the markets and versus their investors. The problem is futures do not offer much protection when markets tank. Besides, investors are understandably reluctant to pay exorbitant fees for something they can do themselves. They are willing to pay as much

Stage 4: Unplug from the matrix: reality is the time in between the “shoulds”

Between the time when Valeant was puffed up to “unsustainable valuations”, and the first analyst to throw the towel with a “Sell” rating, share price actually did go down by roughly -80%. There was no “beam me down Scottie”, exchange between share price and the deck of the Enterprise. Share price did go down over time, but market participants were institutionally blind to it.

Persistent short sellers one day wake up to the fact that between the time when “valuations should normalise” and when “company should collapse”, there is an extended period of time when share price actually does come down. Reality is the time in between the “shoulds”.
Stage 5: DARP: the un-sexy flip-side of GARP
Under-performing stocks are everywhere. They rarely reach extreme valuations, so they never feature on everyone’s target short list. They just trail their sector, the benchmark and eventually drop in absolute as well. They just slowly fade into oblivion, and this is why we have a collective institutional blindspot. There are three main reasons for this: psychological and wrong assumptions
Analysts color blindness
Analysts are color blind: everything has to be either rosy or dark grey. They are usually prompt to raise their ratings and their estimates when fundamentals improve. They are late to downgrade their ratings as they do not want to jeopardise their relationships with corporations, infuriate their investment banking colleagues and volunteer for the next chopping block. Estimates fall but not nearly as fast as they were once raised. There is built-in institutional inertia to factoring decline in ratings and estimates. Meanwhile, old stock market darlings just drop off the conversation and gradually fade into oblivion.
The second reason is psychological. As scientific as it may sound, fundamental analysis is inherently subjective. Facts just aren’t data; they are weaved into “logical” arguments called investment thesis. For fundamental participants to admit a stock could be a short, they must first go through the intellectual divorce of accepting that it is no longer a Long.
Fundamental market participants grieve their way into short selling. They go through the Kubler Ross cycle of grief. Only in the final stage do they finally wake up and accept that the stocks they once loved could be short. Everything prior is discounted, or ratonalised.
DARP: the un-sexy flip side of GARP
Many market participants invest on the Long side following a Growth at Reasonable Price (GARP) methodology. They look for visible growth prospect with reasonable valuation support. They shy away from hyped stocks.
Frothy valuations is the premium market participants put on growth prospects. Once growth prospects disappoint, the premium gets arbitraged away. Valuations come down to reasonable level, on par or at a slight discount versus their peers. This gives the illusion of fair valuation or discount relative to peers.  There is no news flow that would draw attention, such as big earnings revision, or product recall. Yet, growth may continue to be sluggish. Growth stocks move to the value camp, and value stocks drift to value traps. Stocks imperceptibly under-perform their peers, the market. Welcome to the world of Decline at Reasonable Price (DARP).
This notion of DARP is difficult to comprehend for most fundamental investors. They practice Growth at Reasonable Price (GARP) on the Long side.  So, they believe they should do the opposite on the short side. They naturally tend to look for unreasonable valuations coupled with unsustainable growth prospect, or even imminent collapse. As we saw before, the last 5% to the top and from the bottom have claimed more participants than the 90% in between.
Investors struggle to find shorts because they look for the wrong clue. They focus on rich valuations when they should look for relatively sluggish growth. This puts a glass ceiling on share price appreciation, i-e the famous “valuations stay cheap for a reason” argument.
In a nutshell, there is no smoking gun on the short side: profitable shorts do not stand out. The best way to picture a profitable short is to think of it as dull long stocks. On the short side, boring is good. Boring under-performs.
Conclusion: Empty your cup
The short side is is a vastly unexplored continent: the Terra Incognita of short-selling. It has its rules and its dynamics, largely unexplained.
Market participants come to the short side full of the assumptions they carry over from the Long side. The theory that they bring along has a sobering encounter with reality. This brings frustration, disappointment, anger and eventually atonement.
Yet, success on the short side carries its own rewards. Those who master the skill can craft their own performance profile, levy higher fees, attract and retain investors.
The short side has more than one paradox. Whilst volatility is elevated, success comes from looking for stocks that other investors casually dismiss as boring.
Let us know what You think, your experience. Comments are always welcome. Please share with your friends and colleagues

The psychology of stop loss

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Diets don’t work. There has never been as many methods in the history of mankind. Meanwhile, we are all getting fatter year after year. Diets just solve the wrong problem. The issue is not the food we ingest; it is how we relate to it. If instead of juicy, delicious, melting, tender, we associated beefsteaks with increased risks of coronary and cardiovascular accidents, reduced life expectancy, arteriosclerosis, high cancer risk, we might be less inclined to partake in the consumption of the flesh of the holy cow.
Stop losses are like diet. Every knows the recipe: “cut your losers, ride your winners”. Everyone also knows the way to accomplish this as well: stop loss losers. So, why do we all fail ? This is not a statistical problem about calculating optimum stop loss. The issue is the associations we make about closing positions. Stop Loss is an identity issue.
The topic of “stop Loss” deserves a book. This article merely scratches the surface. Yet, You will find powerful tools to reframe your stories and practical tools to set and honour stop losses
The interesting twist on stop loss is even though we intellectually know that we are wrong at least 50% of the time, our ego has us still behave as if we have to be right 100%.

Part 1: Making money on the markets goes against nature

 “Hope is a mistake”, Mad Max, Aussie Philosopher
When people say I don’t believe in stop loss,…
… What they actually mean is I don’t like to admit I am wrong. They are often acutely aware that there is something wrong. Yet, they are willing to take on more pain and more uncertainty hoping that things will turn around and that they will be vindicated. This phenomenon has been studied by Nobel laureates Daniel Kahneman and Amos Tversky and known as risk seeking with losses and risk aversion with profits.justice-for-children
At the heart of this lies a confusion between outcome, i-e making/losing money, and process, i-e investment discipline. If being profitable equals being right, then logically losing money means being wrong. Any loss is therefore a direct attack on the self-image constructed by the ego. Since the ego wants to be right, and will always protect itself at any cost, we will sacrifice profits, endure excruciating pain for long stretches of time, jeopardise our jobs, our reputation even our families. The objective is no longer to be profitable but to validate the ego.
In Jungian archetype, the ego is an unhealthy version of the orphan. It is an early version of our personality, developed during the formative years of childhood. The image of the orphan, abandoned and mistreated, is actually a good metaphor.
Deep inside, the orphan’s intentions are good, he means well. He yearns for love and validation. Yet, as a child, he does not know how to handle situations gone out of control. His natural defense mechanism is denial and deflection. He will delay admission that something is wrong only to preserve ego driven self-image. He will pretend it did not happen. He will rationalise. Since he does not have better problem resolution method, he will show extraordinary resilience and wait until wrong turns back to right, until losses turn back into profits.
Do not underestimate the toxicity of a stubborn ego. Reputations and jobs have gone before egos surrender. Examples of pointless wars, companies run into the ground by narcissistic top management.
Bottom line: we are naturally inclined to let our losers run.

Why we cut our winners

We are not born eager to take profits early, quite the contrary in fact. “Beginners luck” stands for taking big risks on a low probability events, something no seasoned player would never dare. We become risk adverse after a few painful losses. We see profits evaporate before our eyes and want to keep some of it next time. If we never experienced losses, we would not feel the need to be risk adverse with profits. We would gladly embrace the riskiest strategies if it was not for the painful lessons we have learned through losses.
Bottom line: it is in our nature to run losers and then cut winners. Making money in the markets goes therefore against our nature

Part 2 How to re-write the story of stop loss

 

1. Accountability: take responsibility

The job of the ego is to protect itself at all cost, at all times. By now, You have probably concluded that this toxic form of ego has happened to people You know, but that You are immune to it. This makes for (hopefully) a nice read, but there is no need to change. Well, if that thought just crossed your mind, Your ego is playing tricks on You. Self-deception covers is a built-in feature that covers its own tracks. Try those exercise and see for yourself how good You are at deceiving yourself.
Exercise 1: Business is a form of procrastination
What do You do when there are uncomfortably large losses festering in your portfolio ? Do You read every analyst report ? Do You call companies, experts, read every article ? Or do You simply clean your desk ?
Chen & al asked students preparing for exams to grade their assiduity as well as break down their daily activities. Students who put off studying were also found more diligent at cleaning their desk , calling their parents. They were engaging in useful activities as a way to rationalise the guilt of not performing essential duties.
Exercise 2: The naked truth of numbers
In one of my previous jobs, i was fortunate enough to analyse the performance of managers stock by stock. If the three worst performing stocks had been removed from every portfolio, all managers would have outperformed their benchmark (before cost) every single year for the entire sampled period.
So, analyse all your trades and compare the bottom 5th percentile to the top 95th percentile. Download the trading edge vizualiser and run the numbers.
Calculate a 5th percentile tail ratio.
 
Your ego might have tricked You into believing You are rational. It might even have tricked You into believing You were doing the right due diligence, but in the end numbers don’t lie.
 

2. Reframing stop losses

If someone handed You the keys to the sexiest car on the planet, but whispered “brakes don’t work”, would You still take it for a spin ? Stop losses are like brakes. You may not like them, but they will keep You alive.
That simple metaphor is called reframing. It translates an abstract concept like stop loss into something we can relate to. Even though the absolute, imperative, non-negotiable necessity of a stop loss imposes itself beyond any beginning of dispute, we are still unlikely to execute, simply because enforcing them still conflicts our sense of identity. Bottom line, Stop loss is an identity issue.

3. Identity association

For example, diets are healthy, we know that. Yet, the overwhelming majority of people who have successfully lost weight end up putting it back on within a year. They have gone through the physical part, but they maintain unhealthy identity associations with food. Food is not the problem, how we associate to it is.DietsGone wrong
As long as we associate profitability with self worth on a trade-by-trade basis, the ego will trick us into skipping stop losses. We need to consciously associate being right with adherence to an investment process. This shifts focus from outcome (profitability) to process: being right is executing the plan.
This accomplishes two things:
  1. It becomes quantifiable and measurable: one trade is random. 100 trades are a data sample.
  2. It removes the incentive to cheat: being right is no longer an individual trade decision. You can lose money and be right. In fact, this association is stronger than the outcome orientation. It involves the neo-cortex in relationship to the dorso-lateral cortex (siege of identity). It literally rewrite the neural pathways to your identity

4. Clarity: Stop loss is a price, not a fundamental story, not a valuation exercise

Fairness is a trait common to all infants around the world. It manifests itself even before toddlers can speak. The orphan likes boundaries. He likes fairness. He does not like ambiguity. He hates favoritism.
Some people make the mistake of associating stop loss with change in fundamental story or valuation.
  1. Stories: prior to becoming a superstar with Emotional Intelligence, Daniel Goleman wrote an even more interesting book about the lies we tell ourselves. He argued that self deception is a built-in feature that covers its own tracks. We rationalise our bad choices. We will change our beliefs in order to match our actions. If You find excuses to avoid the gym, then You will fabricate excuses to allow losers in your portfolio.
  2. Valuations: Earnings estimates are notoriously inaccurate and jumpy. Forecast accuracy for analysts earnings estimates 1 year out within +/-10% range peaks at 25%, half a coin toss !
If a trade goes sour, You do not lose an investment thesis. You do not lose a P/E, DCF or some Frankenstein sum of the parts valuation either. You do not lose things that were outside your control in the first place.
You objectively lose two things: money and time. Risk is a number: this is how much You can afford to lose
5. When to set a stop loss
The best time to set a stop loss is … 5 minutes before entering a position. Stop losses must imperatively be set before entry
  1. Stop losses are necessary to calculate position sizes. If You do not set a limit on how much You can afford to lose, You may fail to appreciate what the market has in store for You
  2. Emotional interference: Once we enter a position, emotions kick in. Think of it as a prenuptial agreement. Commit to a price in writing, write it close to entry cost and price. Do not trust your brain with some abstract stop loss price. Your brain will renegotiate and it will trick You into a suboptimal decision (marketing buzzword for stupid mistake).
Stop Losses are necessary. We need to know when something is wrong, cut it out and move on for three reasons

6. Pre-mortem: enter each as if You expect them to fail

Everyone knows about post-mortem: this is the quarterly ritual when someone in management goes through your trading decisions with the benefit of hindsight…Grief
Pre-Mortem is a technique invented by Gary Klein: fast forward in time and visualise the decision You are about to make as if it was a failure.
For example, optimism usually peaks before entry. Even though our long term win rate is around 40%, we behave as if every trade was a winner. Consequently, we tend to oversize positions and delay stop loss.
Practice this powerful exercise for a month: just before entering a trade, imagine it will be loser that will have to be stopped out. Visualise yourself closing the trade at a loss, use the present tense. It may seem crazy but it accomplishes two things:
  1. Conservative position size: if you enter a trade expecting it to be a stopped out, You will naturally take smaller bets. You will stay out of illiquid issues
  2. Pre-packaged grief: we normally expect trades to work. When they don’t, we grieve our way to stop loss (Kubler-Ross). We negotiate with the inevitable. Now, if we expect every trade to fail, those which work will be good surprises. That do not perform as expected. It removes the emotional toll.

7. Execute the stop loss: re-parenting

A stop loss is just like any other trade. The difference is the meaning we assign to it can be potentially devastating.
The paradox is that beating ourselves up over losses reinforces the ego. Think of it as an orphan. Children have superb natural resilience. Beat the orphan, shame him, and he will retreat further, deeper. He will drape himself in the warm mantle of anger and call upon his resilience to endure the hardship. The orphan will endure but the child will yearn for forgiveness and love.
There is a link between self-forgiving and learning. Students at U-Penn who were taught to forgive themselves for their lack of assiduity have shparent4own 10% additional retention and 15% better grades than those who were instructed to enforce rigorous discipline. People who forgive and love themselves when they have trespassed their own boundaries tend to learn from their mistakes. In Jungian archetypes, this is the Ruler bringing back the orphan to the committee of the mind and thanking him for his protection. In other words, soothe yourself as if You were talking to your child. This is called re-parenting the orphan.
So, the more You forgive yourself, the less daunting stop loss becomes
The easier it is to execute stop losses, the easier to take new trades
The smoother the execution, the better the performance
Bottom line, forgive yourself for your mistakes and You will become a better portfolio manager.
In conclusion, watch this excellent video from Nobel laureate Daniel Kahneman on mistakes and pre-mortem

Better System Trader 2nd Interview:

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Andrew Swanscott has one of the best podcasts on trading out there. He has brilliantly interviewed world trading champions, legends such as Van Tharp, Larry Williams, Jerry Parker, Perry Kaufman etc. In each episode, there is a nugget of wisdom. One word of caution though: Better System Trader is more addictive than chocolate.BetterSystemTrader

It was an honour to be interviewed on episode 32.

With the recent “soft patch” in global markets, Andrew decided it was time to catch up and go deeper into topics such as psychology. Markets are stressful on the long side already. On the short side, pressure is something else entirely.

Thank You very much for all the questions and comments on the website. If You have questions You would like to ask on the podcast, please go to the link below:

http://bettersystemtrader.com/ask-laurent-bernut/

 

Topics covered this time will probably be:

  1. How to improve your trading edge ? (This is a question from a reader, thank You). A post will follow shortly
  2. Sherlock Vs the Red Queen: why people fail at short selling ? You will understand the trappings in which people coming from the Long side fall. This topic has never been approached from a statistical perspective.
  3. The psychology of Stop Loss: did You notice that your desk is cleaner when You can’t close a bad trade ? We all know that cutting losses and riding winners is the key to success. We will go through evolutionary psychology, affective neurosciences. We will teach You how to reframe stop loss and trade like a psychopath
  4. Jedi trading: if You want to be the iceman on the trading floor and if You want to switch from fight, freeze or flight syndrome to flow state in less than 2 minutes, then practice this technique
  5. if we have time: why You should not be afraid of this bear market, Einstein and monkeys and the importance of Chuck Norris

 

The view from the short-side: how we process emotions and the market signature of the 5 stages of grief

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Market participants are constantly asked to defend their conviction. The moment they have to justify their positions is the moment they lose impartiality. They become attached to whatever they have to defend. Being right is no longer about the process (taking calculated risks), but about the outcome (making money). A losing position is an attack on the ego. For this reason, market participants process emotions through a 5 stage cycle defined by Elizabeth Kubler Ross as the psychology of grief. Each phase has a distinctive market signature and even a specific language.

Summary:
  • Short sellers have a unique perspective on how market participants process emotions
  • The 5 phases described: market regime, market signature, language and profitable course of action

 I have been a professional short seller for almost a decade. For 8 years, my mandate was to under-perform the longest bear market in modern history: Japan equities. I have always searched for a way to identify the signature of human emotions across markets. Many respected market gurus have come up with charts plotted with emotions ranging from euphoria to despondency. Yet, they never really resonated with the short seller in me. Those were written by market participants with a natural Long bias. The short side offers a unique perspective on how investors process emotions. We, short sellers, never sell against buyers. We ride the tails of those who were once holders and now have to “accept” losses and “let go” of attachment.
There are three market regimes: bull, bear and sideways. Each regime can be subdivided into two categories: quiet or choppy. Bear markets usually start in sideways choppy markets: an epic battle between bears and bulls. They usually end in indifference: sideways quiet or bull quiet. Everyone has thrown the towel and no-one cares anymore.
The psychology of grief has five phases: denial, anger, bargaining, depression and acceptance. We will examine each phase looking at the market regime, the market signature, the language and a profitable course of action.
Phase 1: Denial
  • Market regime is usually sideways choppy. Stocks stop making new highs. They are trapped in a volatile range. Short interest is low. Bulls fight bears.
  • Market signature is the compression of estimates. Optimistic and pessimistic analysts have fairly close estimates. All available information has been “baked in” the estimates. The decisive factor is a sudden penetration through support level.
At this stage, analysts jump in and say two things:
  1. This is a “one-off”, “inventory adjustment”, “seasonal adjustment” etc
  2. This is a “Buy on Weakness opportunity”: Analysts are usually quite vocal as they appeal to market participants who were waiting for a pullback to enter a position
If a stop loss was not triggered, it is best to wait until the ensuing rebound is over to make a decision. If the new peak is below the previous high, then start trimming. When in doubt, reduce position size.
Phase 2: Anger
  • Market regime has morphed into a choppy bear. Stocks make lower highs and lower lows. Volatility remains elevated. Short interest start to tick up. Professional short sellers, such as myself, put a chip on the table just to see. Fast money, those who bought the dips and lost money, turn around and engage in some revenge short selling.
  • Market signature is characterized by institutional reducing their weight. Initial sellers are Long Onlys trimming their weights. Mutual funds may well keep their bets over the index, but they still trim their weights so as to reflect under-performance.
At this stage, analysts express their frustration:
  1. “…But the market does not understand …”: that is always an interesting argument, particularly after years of out-performance, institutional participation. Market probably knows something analysts refuse to accept yet
  2. “Short-sellers and speculators are taking the stocks down…”: ignorant analysts and market commentators blame us for stocks tanking, yet facts are stubborn: short interest is low. Secondly, in order to sell short, we need to locate borrow. Borrow availability represents a tiny fraction of the free float. Simply said, we just do not have the might to take anything down.
At this stage, it is prudent to aggressively reduce bet size for two reasons: 1) Volatility remains high and 2) performance does not justify a big position anyway. For market participants with a Long/Short mandate, this is a good time to anchor a small short bet. Position sizing is crucial as volatility remains elevated. Those anchors become invaluable when stocks move into the next phase as they embed substantial profits.
Phase 3: Bargaining
Me: “Doctor, if I eat my vegetables, stop drinking, smoking, eating poorly and exercise more, will I live longer ?”
Doctor: “I don’t know, but it will feel much longer anyway”
  • Market regime shifts from bear choppy to bear quiet. Bears have won the battle.
  • Market signature is a softening of a leading indicator that triggers a downgrade of estimates. Negative earnings momentum attracts short-sellers. Short interest start to rise.
At this stage analysts bargain with their conviction:
  1. “We take our estimates down, we revise our target price, we extend our investment horizon, but…”: Since analysts were ardent supporters, they believe they cannot change their mind at once
  2. “… We keep our Buy rating, because the long-term story is still intact”: the softening is not perceived as the symptom of a disease but a temporary setback
Analysts devote their existence to a few stocks. They know something is wrong but they cannot publicly admit that it is time to let go, but market participants can read through the lines and sell. Price action has already shown some weakness, but quantitative short sellers see negative earnings momentum as the sign to build positions. Short interest rises and so does the cost of borrow. This is when anchoring a small position in the previous phase becomes invaluable: borrow was secured at a cheap cost.
 
Phase 4: Depression
  • Market regime is bear quiet to bear volatile because of short squeezes
  • Market signature is 1) deterioration of newsflow , 2) radio-silence from the analyst community and 3) rapid increase in short interest
At this stage analysts:
  • crawl under their desks: they hardly contact companies or market participants
  • “this is a stock for long-term investors”: to which there is only one retort: “then it should be matched by long-term commissions”. If they frown, sell short…
Short interest rises quickly. The quality of borrow deteriorates (callable stocks, usury borrowing rate etc). It becomes costly and difficult to sell short. As a rule of thumb, do not sell short when short utilization (shares borrowed/shares available) rises above 51%. Volume is thin so any tiny event can trigger a short squeeze. Amateur short sellers are forced to cover, which trigger a cascade of short cover.
Phase 5: Acceptance
When the inexorability of reality sets in, there is a sort of euphoric relief.
  • Market regime is either quiet bull (small higher highs, higher lows) or sideways quiet
  • Market signature is terrible news-flow, massive downgrade from the analyst community, elevated short interest (crowded short). It is also muted price action: stocks do not react to a torrent of bad news anymore
At this stage, analysts are frustrated and no longer afraid to tarnish their standing with companies. They downgrade ratings, estimates and publish some vitriolic content such as:
  1. “Structural short”, “flawed business model…”, “…mismanaged”: it sometimes becomes personal, because analysts had a rough inner journey being champions of a lost cause
When all the negativity, particularly the words “structural words”, does not move share price anymore, it is a sign that the worse is over. There is one logical thing left to do: cover the short and go long.
Discussion
Markets are the ultimate mental sports. As much as we would like to think we are rational, the moment we are asked to defend our opinions is the moment we lose impartiality. The irony is that we intuitively know when something is not quite right. Still, we feel obligated to defend our stance. We refuse to admit reality, so we go through a painful process that eventually leads to acceptance. Pain is inevitable, suffering is optional. Making money in the markets is not about trying to be right, it is about accepting to be wrong and move on. Would You like to learn simple powerful techniques designed to reconcile the need for conviction and the reality of losses ?
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