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

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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4 replies
  1. Al Joe says:

    Dear Mr Bernut

    Thank You for a Great Post ! Humbly; It can also Culminate in a to a Bear Volatile Last gasp Lower & Followed by a V Recovery. Can this stand a chance to Fit in the above Cycle.

    Request Your Views ! Again Thank You for your Posts !

    Warm Regards

    Al Joe

    Reply
    • lbernut says:

      Hello Al Joe,

      You are absolutely right. I wish i could memorize or discern patterns
      Lower Lows Lower Highs : Bear
      Higher Highs Higher Lows: Bull

      Bears start in high volatility: homeric battle between sellers and buyers
      Bears end in indifference: no-one owns it anyways, so who cares
      Understanding the high volatility really made the difference, I started sizing positions small after that

      Once again thank You for ryour comment

      Reply

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