The moment of maximum pain.
Goldman Sachs called for the end of the epic short-covering rally that had whipped crude oil, oil & gas drillers, and the broader markets into froth over the past three weeks. As if on cue, the rally started to unwind today. But it was scheduled for demise from get-go. When oil fundamentals are this terrible, they eventually rule.
And here is what that rally did: It inflicted maximum pain and destruction on the short sellers that had piled into the trade.
Last week was the climax of a run that had started on February 12. Crushed energy companies, especially those lurching toward bankruptcy – the most shorted companies around – had a blistering week as short sellers had to buy back shares to cover their positions, or else get their heads handed to them.
When a stock you’re shorting rallies 100%, you face total wipe-out. But it doesn’t stop there. Losses are theoretically unlimited. If the stock rallies 200% or 300%, you lose multiple times the amount of the original bet. If your bet was big enough, you might lose everything you own. Shorting is not for those who easily vomit.
And no one feels sorry for shorts when they get massacred. “Serves them right,” is the normal response. “How dare they bet against me!”
Skyrocketing 200% or more in three weeks is precisely what some of these near-bankrupt most-shorted stocks did. But the short-covering rally extended far beyond a few energy stocks. Christine Hughes, Chief Investment Strategist at OtterWood Capital explained the phenomenon this way:
Since the February 11th low, the best performing stocks in the Russell 1000 have been the names with the highest short interest (short interest is the amount of shares investors have sold short but not yet covered).
In terms of short interest, the top quintile – the 20% most shorted stocks – in the Russell 1000 jumped 27.1% in three weeks. The next quintile rose 16.4%, and so on. The chart Hughes cited shows the dynamics of the short-covering rally, and supports the theory that that’s all it was:
One of the most shorted stocks going into the rally was Chesapeake Energy. By mid-February, short interest was 235 million shares, about 40% of the public float! Any squiggle in the market triggers fear among short sellers of losing their house and first born, and they scramble to cover their short positions by chasing the now soaring shares skyward to try to buy them at ever more elusive prices.
It’s a terrible feeling. It’s the moment of maximum pain. But their concerted efforts to buy these shares at whatever price reverse a crash. Shorting is a form of plunge protection!
Chesapeake ended February 12 at $1.59 a share. On March 7, shares closed at $5.23 a share. They’d rallied 228% in three weeks. For shorts, an excruciatingly painful event. And the very fear of getting mauled like this contributed to this epic short-covering. But today, the short squeeze came unglued, and shares re-plunged 18% to $4.27.
Shorts betting that the shares will go to zero in a debt restructuring may ultimately be proven right, but if timing is off by only a few days, they may, so to speak, lose their house and first-born in the process.
The bitter irony? The short-covering rally in the energy sector was driven by the short-covering rally in crude oil, but Chesapeake gets 72% of its production from natural gas, 11% from natural gas liquids, and only 17% from oil.
Alas, US natural gas hasn’t participated in the rally. It’s still trading at totally collapsed prices, after a death spiral that started in 2009. It has already pushed smaller natural gas drillers into bankruptcy. Folks are betting that Chesapeake, the second largest natural gas driller in the US behind Exxon, is the big whale, and that the natural gas bust will only end after that big whale washes up on the beach.
That equations hasn’t changed. The price of oil is nearly irrelevant to Chesapeake. Yet, its shares rallied more than those of oil drillers.
The logic of the shorts can be perfect, but if timing is off by just a few days and a temporary miracle happens or the CEO utters some ludicrous piece of hype, then shorts get their heads handed to them.
And that’s why I no longer short anything, no matter how obvious the bet, not even the “short of a lifetime.” I leave that up to braver souls. Because it’s just me out there, against the forces that will hype the shares with all their might, supported without questioning by much of the financial media, and they all try to run shorts into the ground as if that were their patriotic duty.
But a megaphone that is big enough to trigger the crash of a stock takes some risks out of shorting. Short sellers like Citron Research or Muddy Waters poke around the company and find some dirt. After they quietly take a short position, they publish their research via their big megaphone, and it shows up everywhere.
If the stock, like Valeant, is a hedge-fund darling, the reaction is brutal. Hedge funds, aware of the first-mover advantage, try to get out the door first, thus guaranteeing a selling spree that spooks other investors. And it spreads from there. After shares have plunged 75%, we find out that Citron has exited its short position, laughing all the way to the bank.
But short sellers that cannot cause a stock to crash and simply follow their own logic, figuring perhaps correctly that Chesapeake is heading toward zero, can become cannon fodder within a few days. And that’s how it was designed to be.
Just how overvalued are stocks, particularly small-caps? According to Wall Street, even the question is wrong! Stocks are always a buy. The future looks bright. And even if it doesn’t, analysts come up with “adjusted” earnings to blind even innocent bystanders. But now, actual earnings are tanking and P/E ratios are blowing out. Read… OK, I Get it, this Stock Market Is Going to Be a Mess