Despite Everything, Don't Go Short

by: Tautvydas Marciulaitis

Most investors agree that equity valuations are stretched - however, going short is not a good idea.

Demand side is artificially boosted and until that changes, one should remain neutral.

There are two key factors, which you should focus on.

Many traders and investors, especially those new to this business, are usually prone to cognitive biases. They generalize, project their ideas onto the market and believe that reality should match their expectations (but not vice versa). These biases can be observed when everyone agrees that something should happen, however that something simply does not happen for extended period of time.

Like now - everyone agrees that equity prices are relatively high and should return to more historically appropriate values. Thus many jump to conclusion that it is a good time to start shorting. However, in reality, naked shorting could lead to disastrous consequences.

New highs every month

Despite consensus among traders, analysts and even central bankers about the fact that valuations are rich in equities, equity indices keep rising further:

Chart ^SPX data by YCharts

So is everyone wrong ? Should I put on some shorts ? Or maybe it is time to become the dip-buyer ?

Well, to answer the first question, everyone is right. Equity valuations are actually very rich and current levels are hardly justifiable, given the bigger micro, macro and geopolitical context.

Nevertheless, the fact that everything is expensive does not mean that you should liquidate your whole portfolio, or go short. It may sound counter-intuitive, however the sole fact that valuations are overstretched does not mean that prices should start going down immediately. And, in addition, that one should liquidate investment portfolio.

In fact, at times like this the biggest winners are those, who understand risks clearly and do not add to their positions, however sit tight and ride the trend for as long as possible. That is what professionals do.

On the other hand, rookies liquidate their holdings more or less immediately after first warning shots are fired. As time passes and markets keep on going up, they look for some action (it is boring to sit without positions) and thus go short, trying to fight the trend. And that rarely ends well.

So it is not the best idea to go short now. Until current trend ends, naked shorting can be very expensive and frustrating. And to understand what will constitute the end of this trend, one needs to answer the following question - if everyone thinks that prices are too high, who is buying and creating this trend ?

Stock buyback programs

Last year this was a very hot topic. Analysts kept telling that the only thing that keeps the stock market alive is buyback programs. And there were some good reasons to say that. Take for example this line from FactSet's buyback quarterly:

Buyback Spending Exceeds Earnings for 119 Companies: 119 companies in the S&P 500 spent more on buybacks in the trailing twelve months ending in Q3 than they generated in earnings.

That's right, almost quarter of largest US companies at the end of last year were spending more money on buyback programs than they were earning.

And if that's not scary enough, looking at data compiled by Yardeni, one can observe that total amount spent quarterly on buybacks from 2012 to 2017 averaged approximately 150 billion US dollars. While total average S&P 500 market cap, during the same time, was ~19 trillion USD.

Thus, for those 5 years S&P 500 companies were buying back approximately 2-3 percent of the total market cap every year. Amounting to 10-15 percent during the whole period. And that's only considering the largest US companies.

Source: Yardeni

These are extraordinary amounts of money which feed into the market regularly. Thus, your shorts worth 100 thousand dollars are pretty much non-existent in comparison to the amounts being bought by companies themselves.

Why is everyone doing that ?

Well, in the world where everything, from management's bonuses to companies' performance in stock market, is determined by changes in Earnings Per Share, it is only natural that everyone tries to boost it in any way possible.

As cost of debt is driven down by prolonged period of expansionary monetary policy, thus decreasing the usual ratio of cost of debt to cost of equity even further, many companies started to issue more debt and use this money to fund stock buybacks.

In addition to theoretical cost decreases and tax optimization, when you decrease number of shares, EPS increases even if earnings stay constant. Thus, stock buyback programs seem to a be very lucrative solution, as it helps company in every way - from cost reduction, to market performance.

When will they stop ? Well, looking at the same research by Yardeni and using common sense, we can conclude that buyback programs are highly correlated with monetary policy and interest rates. Following the monetary policy cycle, stock buybacks have been increasing since 2009 and started to decrease in 2015.

Thus, the faster FED increases rates, the less buybacks there will be. In addition, as FED starts to decrease its balance sheet, bond markets should tumble, making financing through debt issuance more expensive and leading to even less buybacks.

Price insensitive behemoths

Institutional and retail investors usually trade in order to make money and outperform the market. For the most of us making as much money as possible from trading and investing is the only thing that makes sense.

However, some market participants are very much different. Not only they have no ambitions to outperform anything, they are also insensitive to price changes. Meaning that they do not really care whether prices of their holdings will go up, down or sideways.

Who are these mythical creatures, you may ask ? Well they are such institutions as Swiss National Bank, Norwegian Sovereign Wealth Fund and pension funds of different rich western countries.

Take a look at top positions held by Swiss National Bank (full list):

Source: Nasdaq

The key numbers are highlighted. As seen from this report, SNB has ~3 billion in Apple, ~2 billion in Microsoft and a bit over billion in some other blue chips. In addition to the position sizes, they all are being increased.

One may find a more detailed explanation about how these players affect markets here, however put simply, such entities have more or less unlimited resources. SNB may issue money (definition of unlimited cash), NSWF is worth 7.6 trillion Norwegian kroner (~800-900 billion US dollars) and pension funds get monthly cash injections from number of high-earning westerners. Thus they can buy whatever they want, whenever they want.

Nevertheless, they all have purpose, which is not to make money, but rather to create long term (meaning centuries, not 24-36 months) wealth and generate constant cash flows.

As bonds started to yield zero, these entities went out to hunt for yield. And as everyone else they ended up in buying some strange stuff from all over the world. However, as retail investor may buy some sketchy ETFs, which invest in third tier Kazakh companies, these large entities have too much liquidity to swim in shallow waters.

Thus they put their focus on equities. And these actions are having two core outcomes for the equity markets:

1) Size of such institutions means that when they start buying something, they will buy insane amounts of it. For example, when NSWF decided to increase its equity holdings by 10 percent, it meant that more than 80 billion of USD will be invested in some stocks. Given average S&P 500 daily liquidity is ~550-580 million USD, 80 billions equals to 140 days of that. And that is only one of the institutions;

2) As these institutions do not need to generate capital gains over short, medium or whatever term, and they need only cash flows (to cover outflows expenses) in addition to increase in wealth over very long periods of time, the equities they buy may not be sold in a lifetime or as long as they fit the strategy (pay dividends so to say);

Thus demand from these institutions is one-sided. They only buy and never sell. They have tremendous amounts of money and as they have regular inflows, usually exceeding outflows, their buying power tends to increase over time. The only scenario in which they may start selling is 1929 or 2008 all over again.

What to do?

Well the key point here is simple - stop thinking about short selling. Because shorting into billions of buybacks and insensitive behemoths is pure nonsense. As long as they keep buying regularly and large institutional investors do not panic, equity markets won't crash.

Therefore one must stay calm and neutral. Risk parity and CTA crowd will be forced to sell when (and only when) there is large spike in volatility, which would last for more than couple of days. Only if such event occurs, algos and people might panic and start selling everything because valuations are rich.

Thus there needs to be a trigger. Just like in 2008, or before any financial crisis. Remember that crisis do not materialize from thin air. Years before every bust most of professionals agree that prices are too high. Risk management can tell you that everything is too high 5 years before the crash.

But it is not about being smart enough to tell if something is expensive. It is about being professional enough to sit through the phase, where everything is expensive but frustratingly enough keeps getting more and more expensive. And selling only when something (or someone) pops the bubble.

Just follow the sentiment and big players. They operate with large sums of money and mainly react to changes in monetary or macro conditions, based on rational expectations. So either try to follow what big money is doing and do not panic until they start to, or just have an eye on VIX and wait for a longer-lasting spike in volatility.

Chart ^VIX data by YCharts

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.