The moment of maximum pain.
Goldman Sachs called for the end of the epic
short-covering rally that had whipped crude oil, oil & gas drillers, and the
broader markets into froth over the past three weeks. As if on cue, the rally
started to unwind today. But it was scheduled for demise from
get-go. When oil fundamentals are this terrible, they
eventually rule.
And here is what that rally did: It inflicted
maximum pain and destruction on the short sellers that had piled into the
trade.
Last week was the climax of a run that had started on February
12. Crushed energy companies, especially those lurching toward bankruptcy –
the most shorted companies around – had a blistering week as short sellers
had to buy back shares to cover their positions, or else get their heads
handed to them.
When a stock you’re shorting rallies 100%, you face total
wipe-out. But it doesn’t stop there. Losses are theoretically unlimited. If
the stock rallies 200% or 300%, you lose multiple times the amount of the
original bet. If your bet was big enough, you might lose everything you own.
Shorting is not for those who easily vomit.
And no one feels sorry for shorts when they get
massacred. “Serves them right,” is the normal response. “How dare they bet
against me!”
Skyrocketing 200% or more in three weeks is precisely what
some of these near-bankrupt most-shorted stocks did. But the short-covering
rally extended far beyond a few energy stocks. Christine Hughes, Chief
Investment Strategist at OtterWood
Capital explained the phenomenon this way:
Since the February 11th low, the best performing stocks
in the Russell 1000 have been the names with the highest short interest
(short interest is the amount of shares investors have sold short but not yet
covered).
In terms of short interest, the top quintile – the top
20% most shorted stocks – in the Russell 1000 jumped 27.1% in three weeks.
The next quintile rose 16.4%, and so on. The chart Hughes cited shows the
dynamics of the short-covering rally, and supports the theory that that’s all
it was:
One of the most shorted stocks going into the rally was
Chesapeake Energy. By mid-February, short interest was 235 million shares,
about 40% of the public float! Any squiggle in the market triggers a
fear among short sellers of losing their house and first born, and they
scramble to cover their short positions by chasing the now soaring shares
skyward to try to buy them at ever more elusive prices.
It’s a terrible feeling. It’s the moment of maximum pain. But their concerted
efforts to buy these shares at whatever price reverse a crash. Shorting is a
form of plunge protection!
Chesapeake ended February 12 at $1.59 a share. On March
7, shares closed at $5.23 a share. They’d rallied 228% in three weeks. For
shorts, an excruciatingly painful event. And the very fear of getting mauled
like this contributed to this epic short-covering. But today, the short
squeeze came unglued, and shares re-plunged 18% to $4.27.
Shorts betting that the shares will go to zero in a debt
restructuring may ultimately be proven right, but if timing is off by only a
few days, they may, so to speak, lose their house and first-born in the
process.
The bitter irony? The short-covering rally in the energy
sector was driven by the short-covering rally in crude oil, but Chesapeake
gets 72% of its production from natural gas, 11% from natural gas liquids,
and only 17% from oil.
But US natural gas hasn’t participated in the rally. It’s
still trading at totally collapsed prices, after a death spiral that started
in 2009. It has already pushed smaller natural gas drillers into bankruptcy.
Folks are betting that Chesapeake, the second largest natural gas driller in
the US behind Exxon, is the big wale, and that the natural gas bust
will only end after that big wale washes up on the beach.
That equations hasn’t changed. The price of oil is nearly
irrelevant to Chesapeake. Yet, its shares rallied more than those of oil
drillers.
The logic of the shorts can be perfect, but if timing is
off by just a few days and a temporary miracle happens or the CEO
utters some ludicrous piece of hype, then shorts get their heads handed to
them.
And that’s why I no longer short anything, no
matter how obvious the bet. I leave that up to braver souls. Because it’s
just me out there, against the forces that will hype the shares with all
their might, supported without questioning by much of the financial media,
and they all try to run shorts into the ground.
But a megaphone that is big enough to trigger the crash
of a stock takes some risks out of shorting. Short sellers like Citron
Research or Muddy Waters poke around the company and find some dirt. After
they quietly take a short position, they publish their research via their big
megaphone, and it shows up everywhere.
If the stock, like Valeant, is a hedge-fund darling, the
reaction is brutal. Hedge funds, aware of the first-mover advantage, try to
get out the door first, thus guaranteeing a selling spree that spooks other
investors. And it spreads from there. After shares have plunged 75%, we
find out that Citron has exited its short position, laughing all the way to
the bank.
But short sellers that cannot cause a stock to crash and
simply follow their own logic, figuring perhap
It’s a terrible feeling. It’s the moment of maximum pain.
But their concerted efforts to buy these shares at whatever price reverse a
crash. Shorting is a form of plunge protection!
Chesapeake ended February 12 at $1.59 a share. On March
7, shares closed at $5.23 a share. They’d rallied 228% in three weeks. For
shorts, an excruciatingly painful event. And the very fear of getting mauled
like this contributed to this epic short-covering. But today, the short
squeeze came unglued, and shares re-plunged 18% to $4.27.
Shorts betting that the shares will go to zero in a debt
restructuring may ultimately be proven right, but if timing is off by only a
few days, they may, so to speak, lose their house and first-born in the
process.
The bitter irony? The short-covering rally in the energy
sector was driven by the short-covering rally in crude oil, but Chesapeake
gets 72% of its production from natural gas, 11% from natural gas liquids,
and only 17% from oil.
But US natural gas hasn’t participated in the rally. It’s
still trading at totally collapsed prices, after a death spiral that started
in 2009. It has already pushed smaller natural gas drillers into bankruptcy.
Folks are betting that Chesapeake, the second largest natural gas driller in
the US behind Exxon, is the big wale, and that the natural gas bust
will only end after that big wale washes up on the beach.
That equations hasn’t changed. The price of oil is nearly
irrelevant to Chesapeake. Yet, its shares rallied more than those of oil
drillers.
The logic of the shorts can be perfect, but if timing is
off by just a few days and a temporary miracle happens or the CEO
utters some ludicrous piece of hype, then shorts get their heads handed to
them.
And that’s why I no longer short anything, no
matter how obvious the bet. I leave that up to braver souls. Because it’s
just me out there, against the forces that will hype the shares with all
their might, supported without questioning by much of the financial media,
and they all try to run shorts into the ground.
But a megaphone that is big enough to trigger the crash
of a stock takes some risks out of shorting. Short sellers like Citron
Research or Muddy Waters poke around the company and find some dirt. After
they quietly take a short position, they publish their research via their big
megaphone, and it shows up everywhere.
If the stock, like Valeant, is a hedge-fund darling, the
reaction is brutal. Hedge funds, aware of the first-mover advantage, try to
get out the door first, thus guaranteeing a selling spree that spooks other
investors. And it spreads from there. After shares have plunged 75%, we
find out that Citron has exited its short position, laughing all the way to the
bank.
But short sellers that cannot cause a stock to crash and
simply follow their own logic, figuring perhaps correctly that Chesapeake is
heading toward zero, can become cannon fodder within a few days. And
that’s how it was designed to be.
Just how overvalued are
stocks, particularly small-caps? According to Wall Street, even the question
is wrong! Stocks are always a buy. The future looks bright. And even if it
doesn’t, analysts come up with “adjusted” earnings to blind even innocent
bystanders. But now, actual earnings are tanking and P/E ratios are
blowing out. Read… OK, I Get it, this Stock Market Is Going to Be a Mess
