WHY IS SHORT SELLING SO HARD?

Low interest rates, share buybacks and low currency volatility make profitable short selling very difficult

To keep this note within a 5 minute read, I am going to leave out a lot of background on short selling. I will do a companion podcast explaining short selling in more detail.

The first and biggest impediment to profitable short selling has been that the cash proceeds from short selling have been far less than the dividend yield on the S&P 500, making short selling a negative carry trade.

Share buybacks have also made short selling very difficult. Shares outstanding for the entire S&P 500 fell from 2011 to 2020, before Covid drove a increase in equity issuance.

Share buybacks moves marginal valuation from being set by a free exchange between disinterested parties, to marginal valuation being set by the management of the firm arbitraging the cost of debt and equity. With debt so cheap, we have seen this arbitrage dominate market valuations. Perhaps there has been no more successful example of this arbitrage than Apple. The earnings yield (PE ratio inverted) has moved to be much closer to the yield on its long dated bonds in recent years.

This higher valuation for its equity has been driven by significant share buybacks since 2016 and large increases in bond issuance (despite strong cash flow).

While Apple is an excellent company, the same process has been at work with almost all US listed companies. A good example would be an aircraft leasing company Aercap. While you can say many positive things about Aercap if you wish, commercial aircraft leasing strikes me as an industry that would be looking more risky than it was in 2019. However for Aercap’s share price, only bond yields seem to matter.

The problem with low yields and short selling have been obvious for years. But the experience of Japan, which has had lower yields for longer than anyone else showed a third way to profit from short selling - currency volatility. As a rule, when USD/JPY volatility rose, the Nikkei fell. This rule still looks largely true, but for the past three to four years, currency volatility has all but disappeared, and the Nikkei has continued to rally.

Readers of my website, will probably recognise that most of my posts are trying to work out whether this is the world we will stay in forever, or are we at an extreme, before mean reversion takes over. The answer, as far as I can tell, is a political one. Will the political winds change to favour labour over capital, or is the position of corporates in the US so entrenched, that pro-capital policies can never be reversed? China has already moved to pro-labour policies, so it can be done. Will the US follow? That is the trillion dollar question. If the US does follow, then short selling will become trivially easy.