Shorting a market, profiting from its decline, was never easy. Situation made itself even more complicated after 2008 when central banks started to use whole arsenal of their tools to manipulate markets. To create an illusion of growth and prosperity they gambled with equities and the real estate. Last bull market was there because of ZIRP, global increase of money supply and central banks being on a shopping spree and buying stocks directly. The Bank of Japan and the Swiss National Bank openly admitted investing in shares or REITs. Basic critical thinking tells us that other banks probably have done the same but not everyone is required to publish reports complex enough to show everything.

It seems like recent boom ended between May and August last year. Since then majority of markets recorded dozen percentage points of decline. The most resilient exchange can be found in the US with only 5% below peaks of last year. With this being said, equities in the US are among the most expensive ones in the world. Market CAPE at the end of January was equal to 23. Today is even higher. Recap: if you see CAPE above 20, it’s a bubble. Huge overpricing is confirmed by Price/Equity ratio of 1.8. The highest in 15 years. In other words, American stocks are very expensive and may be a good option to short. 

Assets are not equal

Pricing of respective sectors or indices are dramatically different. In American stock exchange we can find neutral stocks right near equities being a result of a speculative bubble waiting to burst. When shorting assets we should select those with the biggest potential for plunge.

For example, CAPE of Dow Jones Transportation index is equal to 12. This index is neither cheap nor pricy. The S&P 500 nearly doubles this number – at 23. Another instance of very expensive stock is Russel 2000 index where publication of the P/E ratio was halted as majority of its components (companies) don’t record any profits.

How to look for chances to short successfully?

First and foremost, we have to know what markets are extremely overpriced and thanks to that we have a great potential to fall. Very good analysis is given by German website StarCapital, especially their stock market overview for each region. One disadvantage is that updates are usually made every quarter.

After we picked interesting market we have two choices. The easier way: we can short the whole market. The harder way: pick a sector with the biggest potential to fall. It is important because ‘fashionable’ sectors with very high peaks are the same ones to experience the most spectacular dives. Example of that is a comparison of a biotech sector and a wide market represented by the S&P 500.

Source: finance.yahoo.com

As you can see above, extremely expensive biotech (blue) fell by 24% even though the whole market (red) fell only by 4%.

Picking the right sector has one simple rule to follow. The more expensive share is (measured by CAPE, P/E, P/S or dividend) the bigger its slide will be. I avoided using P/BV (Price/Book Value) ratio on purpose. For sector comparison it’s useless as commodity producers have it often below 1 and tech companies peak over 3 or even 4.

Case of ‘fashionable’ sectors looks similar. Between 2011 and 2015 capital was lured into biotech market and BBH ETF price tripled. Right before the peak was reached a significant surge was fuelled by amateur investors (“I buy because it grows”) who pumped a lot of money during the moment when fundamentals and common sense can’t be found in the market. In circumstances when trendy sector’s growth is lowered – or even worse – starts a rapid nosedive, capital is evacuating quicker than from neutral sector with strong fundamentals or stable revenues.

Today market gives us many opportunities to short. One of the REITs investing in shopping malls in the US caught my eye. The Simon Property Group.

Here are few reasons why I got interested:

a) No matter what mainstream media propaganda tells me I see the US experiencing an economic slowdown.

b) Unprofitable chain stores sell their shopping centres and this in turn affects demand for new shops.

c) Problems in retail very strongly affect rent payments that are correlated with REIT’s revenue.

d) Shares of SPG are overpriced. The P/E ratio is at 35.

e) Dividend equals 3.04% and during last 10 years it varied from 2.35% - 14.62%. This puts SPG in 8% of REITs with the lowest dividend. Knowing that REIT’s structure makes it pay out majority of its revenue, SPG is expensive from every perspective.

f) Dividend payout ratio equals 1.26. It means that company paid 26% more than it earned in dividends. Those who manage this REIT try very hard to show that its company is in a better condition than in reality. Paying out dividend higher than revenues is only possible when latter are continuously rising. It looks like the opposite is more likely to happen.

g) REIT price is strongly linked to equities. If the slump continues (which I believe is the case), it immediately will be felt in price.

As shown below, during 2007-2009 bear market the US REIT ETF lost 72%. This is worse than the stock market. On top of that, economic situation in the US is incomparably worse than 8 years ago.

Source: finance.yahoo.com

How to short a REIT?

The easiest way is to use the CFD – Contract for Difference – available from brokers. In a very simple way we can open our short position, which will generate money when the price of the asset decreases. When the opposite happens – asset appreciates – we can lose our capital.

The CFD has a very specific disadvantage – an inbuilt leverage. Let’s say that you would like to open a short position with my 10 000 USD. After doing that, broker will take only 2 500 USD of your money. The rest – 7 500 USD – he will lend you even if you are not short on cash. Including a forced loan, costs are smaller than the real cost of ‘inverse’ funds (ones that make money out of shorting assets) and are about 2.4%.

Generally, I don’t use leverage anymore. If I have 10 000 USD to open my position with I will deposit the 7 500 USD (amount I am left with after giving 2 500 to a broker) and not use It for any transactions. This money gives me security that when something goes wrong (temporary loss exceeds 25% - equivalent of required 2 500 broker’s deposit) I have funds to cover any backfire.

Leverage is lethal. Avoid it if you can!!!

Why talk about shorting now?

At the end of last year and in January we saw significant bear slides. This was a result of rate hike in the US. Since 10th February we saw a bounce due to the EBC’s decision to increase money supply. Right now prices of many assets are so high that it may be the perfect moment to short. In the case of SPG its RSI is close to 70 (overbought, overvalued).

What risks are involved when shorting?

If banks hadn’t intervened so many times, we would see prices of stocks at least 50% cheaper. Seeing soaring market prices in developed countries you witness the result of increased money supply, ZIRP and direct acquisitions by central banks. In my opinion, recent rebound was only a correction in bear market rather than a return to bull’s path. If I am correct, shorting will give very satisfying returns. If I am wrong, being a bear may generate losses but only temporarily.

Central banks desperately try to sustain high prices of assets. The ECB prints 1 trillion EUR per year. More than the FED during QE3. What is more, the rate hike in the US seems to be merely a one-time event and a possibility of interest rates going down again is rising. All those machinations have no impact on the real economy but pushing interest rates down and QE will postpone price adjustment back to reality. In plain English, central banks may buy themselves few more months of stagnation or even marginal climbs.

Inflation

The real rate of inflation of the USD is 7-8% per annum. Given that share prices won’t change in one year time in real terms they lose 7-8% - the rate of inflation. If inflation accelerates while equity prices hold still it will mean that in a controlled and invisible way we can walk through recession in calm 5-6 years. The result of a recession will be similar to the one we experienced during rapid nosedives lasting maximum of 24 months.

In the past we already had this ‘hidden’ bear market between 1965 – 1979. Nominal prices kept their range between 600 – 1000 pts with standard ups and downs but it was inflation that massacred the prices.

Short selling in those circumstances may be hard in a way that in real terms (with inflation calculated) prices of shares are going down but nominally they stay the same. Thanks to that, a short selling generates costs of 2-3% each year. At the end of the day we would lose money.

Counter-arguments

In most of the cases market slump is rapid and brief. Between 2007 and 2008 inflation in the US calculated by methods from ‘80s broke 10%. Nonetheless, REITs lost respectively 65% and 72%. Inflation was paled by one event. The bankruptcy of Lehman was the sole driver of the mood and overwhelming panic in the market of financial instruments.

Summary

The example of Simon Property Group I highlighted above is, in my opinion, very interesting option to short. The potential is huge but you have to be prepared for some risks:

a) You face very influential players: central banks. Through destruction of currency it won’t be hard for them to artificially keep up the price.

b) When short selling, I wouldn’t risk more than 10% of my capital. It is way easier to profit by being a bull especially when inflation is rising.

c) SPG is only one from many attractive occasions. It doesn’t matter whether you short selling or hoping for new peaks, never put more than 2-3% of your capital into one asset. No one is able to predict the unpredictable and sometimes things go badly wrong.

d) Shorting is an exercise of your discipline and requires nerves of steel. You can try to jump on the rising trend very early and reap the benefits from the very beginning but chances for that are low. Maybe after a new record the price will refuse to go down and continue climbing. How will you react? Are you going to analyse situation with a clear head or are you going to lose it?

Short selling is definitely not for everyone. Playing against central banks, inflation and costs of keeping your position make bear positions harder than bull ones. Still, the situation we see now makes it attractive to do so. Another argument for that is a very high capitalisation of equity markets in relation to balances of central banks.  From the point of view of global central planners the only thing more important than high equity prices is high bond prices (low yield). Thanks to that they try to reduce global indebtedness and control the derivatives market. I believe that probability of equities falling, including aforementioned REIT, is significantly higher than losses in the bond market. As always, time will show whether I’m right.

Trader21