Short Squeeze, Panicked Institutional Sellers Have Been Warping Valuations

The well documented troubles of many quant-driven funds have lacked a key description of their problems and the behavior of certain stocks involved in the turmoil. That is, illiquidity and short squeezes have produced some huge, and I submit unsustainable, price movements in many of the names these funds have sold and covered. Volume exploded on many of these stocks without commensurate news justification.

In general, the highest shorted stocks, with the least liquidity, and less institutional ownership (which affects borrowability) have had the biggest run-ups and the least shorted, most liquid stocks, with high institutional ownership have had the largest declines. Inside of the broad market dynamics, this relative performance relationship has two explanations.

First, the long/short hedge funds have been hurt badly in their efforts to cover shorts. This is due to a squeeze from the harder to borrow stocks and general illiquidity, plus info travels fast on the street, so vultures have probably been front running them a bit, trying for a profitable quick flip at their expense. Second, the same hedge funds and other active institutional investors are aggressively dumping some solid names, but for differing reasons.

The hedge funds are selling to raise cash and meet collateral requirements and they go to where they can find liquidity. As for many active, non-hedge fund managers, I believe many are getting out of some profitable, liquid names to raise cash and lock in some benchmark outperformance during this turbulence. As academic studies have shown, professional investors are quicker sellers for non-fundamental reasons (their year-end outperformance bonuses are in jeopardy!) then non-professional investors during downturns. The stocks with the highest institutional ownership decline more in market sell-offs than less institutionally held stocks. This has been happening in conjunction with the 'quant quake'.

In both cases there isn't the company-specific news to justify the price changes, and the reasons and pressures underlying the behavior shall eventually pass, leading to performance reversion. Timing will be an issue, and the relative performance spread, of the oversold versus the market, or the oversold/overbought combo, might widen before the reversal, but rest assured a reversal will come, and it will be big. Just be ready to jump in.

Comments

[Malkiel:]

I've gotten the impression from this time a year ago through today that many of the biggest gaining days on the market came as a result of "short squeezes", which retail investors can profit from by buying the long or short market index ETF's. It may be that a substantial part of this market's gains in the last year were from failed shorting, essentially redistributing wealth from the short quant hedge funds back to the rest of us. If the hedge funds and bear managers had wised up sooner and cut back their shorting the result might have been as bad for the market as the current credit squeeze...

2007 Aug 20 10:55 AM

[dkco:]

While it might seem that short squeezes have been behind some pops in the market, or at least select highly shorted stocks, in general, high short interest stocks have been consistent UNDERperformers YTD, and over time. The "long term" negative view, say 6 months, of these stocks pans out - they lag their peers. The poor fundamentals or other demerits of these stocks which lead to them being shorted tend to limit their upside over time, unless a short term squeeze lifts the price.

Now remember, it is the poor fundamentals or overvaluation that leads one to decide that a stock is worth shorting, not that it already is heavily shorted. One big lesson everyone will take away from this current short squeeze trama is that a high short level carries an extra dimension of "squeeze risk", at least in the short term. Thus I think it should not be over-emphasized as a selection factor.

2007 Aug 20 03:33 PM