Short sellers in the US stock market are retreating one after another! "Big short" players face a "darkest moment"

According to the Zhitong Finance and Economics APP, after suffering multiple attacks, the short sellers in the US stock market are retreating, thanks to the gravity-defying bull market, lingering regulatory threats, the army of day traders squeezing stocks like GameStop, and so on.

It may be a tough time on Wall Street right now. Well-known short sellers are facing setbacks, with Jim Chanos exiting due to financing failures, Carson Block's Muddy Waters Capital launching its first long-only fund, and Citron Research founder Andrew Left referring to his peers as a "dying breed".

According to Goldman Sachs data, short interest in typical stocks in the S&P 500 index is at its lowest level in over twenty years. HFR data shows that while the overall size of equity hedge funds has nearly tripled, assets in short funds have declined from $7.8 billion in 2008 to $4.6 billion. The radical strategy advocated by prominent short sellers like Block and Left, which involves finding flaws in companies and betting against them before they are publicly exposed, has seen its slowest start in a decade in 2022, with only marginal growth last year.

Against this backdrop, a series of well-known short sellers have been reducing their short positions, with some already exiting the industry, including some of the most famous investors. Jim Chanos, the legendary short seller known for predicting the collapse of Enron Corp., said, "Our hedge fund business is shrinking, people just don't want to invest. Investors (mainly institutional investors) have given up on the fact that shorting can generate excess returns."

Chanos announced at the end of last year that after nearly 40 years, he would convert his hedge fund into a family office. He stated that there is a lack of interest from investors in bearish strategies, and the fund "cannot cover management fees". Assets have dropped from over $6 billion in 2008 to less than $200 million.

For this controversial corner of the investment world, some praise short selling for exposing corporate scandals like Wirecard, while others criticize it for harming investor interests and exacerbating market volatility. The HFR Short Selling Hedge Fund Index had 54 constituents in 2008, but after years of losses and various strategies experiencing outflows, the index's constituents have sharply decreased to 14.

The goal of short sellers is to buy back borrowed (and then sold) stocks at a lower price, return them to the lender, and keep the profit. However, in a market where stocks seem to only rise, this can be challenging. Over the past decade, the market capitalization of the S&P 500 index has surged by about $30 trillion, more than doubling in size, first driven by the era of ultra-low borrowing costs and more recently by the frenzy of artificial intelligence Morgan Stanley strategist Nikolaos Panigirtzoglou believes that the stock market's "massive expansion" is making it difficult for short sellers to continue. This doesn't necessarily mean that the bearish view is wrong, but the upward trend in the market implies that any bearish arguments will take longer to materialize, while at the same time, the short sellers must pay borrowing costs for the stocks they sell. It's not surprising that, according to Goldman Sachs' estimates, the median bearish position of S&P 500 index companies is currently around 1.7%, only slightly higher than the low point in 2001 and lower than the long-term average levels of various major stock industries.

However, the market's rise is just one of a series of challenges. In 2021, the U.S. Department of Justice and the Securities and Exchange Commission (SEC) found that many aggressive short sellers are under investigation for suspected market manipulation. There have been no charges yet, but the U.S. SEC also finalized regulations last year requiring hedge funds and other large investors to report monthly on certain stocks' total short positions, thereby strengthening scrutiny of this business.

This is part of a global trend of tightening regulations, with short selling also restricted in countries like China and South Korea. This officially expresses widespread suspicion towards traders trying to profit from declines, who have long drawn anger from the companies they target, investors in these stocks, and the financial industry. The former president of the New York Stock Exchange even used terms like "disgusting" and "un-American" to describe them.

Levitt, the founder of Citron Research involved in the Department of Justice investigation, said, "This is a bad business. You just put yourself in the middle of lawsuits between companies and the government. Why would I do that?"

Levitt doesn't believe he did anything wrong, but there have been no results from the investigation so far. At the same time, he was one of the short sellers who suffered painful losses during the 2021 pandemic-induced short squeeze, when retail traders gathered on online forums to squeeze the stocks of companies like GameStop and AMC Entertainment Holdings Inc. (AMC.US), with the most famous being Gabe Plotkin's Melvin Capital Management.

Despite the heavy losses, short sellers became the villains in this turmoil, although they were already accustomed to this role. However, it must be said that this event has brought a new round of negative attention to the industry.

Chanos scoffed at the entire event, saying, "Retail investors buy these worthless stocks and then blame the short sellers, which is absolutely crazy behavior. Short sellers are the ones being crushed by the GameStop phenomenon." "

In the past two months, retail traders have once again shown their skills, with the stock prices of several popular stocks, including GameStop, soaring again. Overall bearish investors may have escaped the worst, as data from analytics firm S3 Partners shows that short interest in this video game retailer has never rebounded after the events of 2021, but this also serves as a reminder of the dangers. In less than a month, a basket of stocks that Goldman Sachs hedge funds were most short on went from nearly 10% losses since the beginning of the year to over 13% gains.

Left said that these "Meme stocks" dramatically demonstrate the "gamification" of the market, which has disrupted the entire short-selling industry. He mentioned that in recent turmoil, he once again bet on GameStop, but only with a small position, and it was for "fun".

"You can't short on scale," Left said. "People now realize that after the GameStop incident, stock prices may rise for various reasons."

All of this helps to curb aggressive short sellers like him. According to data from Diligent Market Intelligence, there were only 110 activities in 2023 compared to 280 in 2015.

The downside potential of short selling is theoretically unlimited. Industry insiders say that it is becoming increasingly difficult to attract new cash for high-risk bearish strategies, whether from aggressive companies or simply bearish hedge funds. After betting on the stock market for over a decade, Russell Clark closed his fund at the end of 2021. His RC Global Fund bet on tech companies in China and the United States, with assets dropping from about $1.7 billion six years ago to $200 million. While his holdings in Asia yielded returns, going against the US market caused significant damage to performance.

Clark said, "If large allocators can make money by going long on the S&P 500 index, why take the professional risk of allocating to hedge funds with a preference for short positions? Before seeing real demand for hedge funds, we really need to see changes in the dynamics of leading stocks."

Chanos said that the current downturn is part of a cycle, similar to the formation of the internet bubble years ago. The problem is that this downturn could last a long time, and he believes it has already lasted for 15 years. During this period, a basket of short stocks from Goldman Sachs has seen an average annual increase of over 9%, while HFR's short bias index has averaged over 10% in losses each year.

Chanos said, "The longer the cycle, the more short selling seems to be questioned and less favored, but this is usually before the dawn of making huge profits."

This view suggests that a continuously rising market not only creates overvalued companies that short sellers eventually feast on, but also masks poorly managed, sometimes even fraudulent companies. When short selling is at a low point, this may be especially true, as bearish activities have been shown to curb misconduct by companies and keep the prices of companies with problematic financial statements in check." Chanos believes that large investors who have abandoned short selling have missed "excellent opportunities." Clark has hinted that he may consider returning to his old business when he deems conditions appropriate. In the past seven months, even Left has released at least two reports, but he stated that he only intends to release reports on rare occasions, and only for what he considers non-"consumer-driven" companies.

Meanwhile, despite Glen Kacher's Light Street Capital Management suffering heavy losses in the initial GameStop incident, he continues to persevere in this business. He has been using more customized baskets to obtain a broader bearish bet. This year, his short positions, along with long positions in tech giants like NVIDIA (NVDA.US), have helped boost the hedge fund's returns.

Kacher said, "There is a large part of the market that consists of passive funds that do not analyze what is happening, which creates opportunities for short sellers."

S3 Partners stated that there have been signs this year indicating a rise in short sentiment from historical lows, with the U.S. adding $76 billion, about half of which is new shorting activity. Data tracking company Breakout Point statistics show that by April, there were 47 new short trades in 2024, and if this pace is maintained, it is expected to add 150 new short trades by the end of the year, a 15% increase from 2023. The company's founder Ivan Cosovic believes that SPACs and ESG-focused investments provide "rare opportunities" for aggressive short sellers.

However, even though global central bank governors have raised interest rates to levels not seen in decades, stock markets continue to rise, making it difficult for bearish bets to last. Goldman Sachs stated that most hedge fund short bets are currently made through ETFs and futures targeting indices rather than individual stocks. These are more like hedging tools rather than inefficient bets on market direction or individual stocks.

Meanwhile, according to data from Acadian Asset Management, borrowing stocks in certain corners of the market has become very expensive, posing another disadvantage for short sellers.

Some bearish investors are looking for other ways to express their views. Muddy Waters Capital LLC founder Block believes that Vietnam is a potential beneficiary of capital reallocation. The rationale behind the company's newly established long fund targeting Vietnamese stocks includes the belief that some regions are "uninvestable." For Fahmi Quadir, the founder of Safkhet Capital, the key to survival and even growth for short sellers lies in finding a strategy that can be profitable even in unfavorable market conditions. She has achieved some significant victories, including betting against pharmaceutical company Valeant Pharmaceuticals near its peak in 2015, and betting against Wirecard before its collapse in 2020.

Quadir said, "You must be able to adapt to the market environment, or at least strive to eliminate the impact of the market environment on your investment portfolio. There is never a good time for short selling."