The Short Seller's Dilemma: Is The Story Broken?

The Three Types of Fear:

The Gross-out: the sight of a severed head tumbling down a flight of stairs. It's when the lights go out and something green and slimy splatters against your arm.

The Horror: the unnatural, spiders the size of bears, the dead waking up and walking around. It's when the lights go out and something with claws grabs you by the arm.

And the last and worst one, Terror: when you come home and notice everything you own has been taken away and replaced by an exact substitute. It's when the lights go out and you feel something behind you, you hear it, you feel its breath against your ear, but when you turn around, there's nothing there.

― Stephen King

Brody: You're gonna need a bigger boat.

― Jaws (1975)

Back in my portfolio manager days, I was a really good short seller. I say that as a factual observation, not a brag, as it's not a skill set that's driven by some great intellectual or character virtue. On the contrary, most short sellers are, like me, highly suspicious of all received wisdom (even when it is, in fact, wise) and have weirdly over-developed egos that feed on the notion of "I'm right even though the world says I'm wrong." But what set me apart as a short seller were two accidents of experience. First, I didn't come out of Wall Street, so I wasn't infected with the long-bias required of those business models. Second, my professional career prior to investing was all about studying mass behaviors and the informational flows that drive those behaviors.

Here's why that's important. The biggest difference between shorting and going long is that shorts tend to work in a punctuated fashion. One day I'll write a full note on the Information Theory basis for this market fact, but the intuition is pretty simple. There's a constant flow of positive information around both individual stocks (driven by corporate management) and the market as a whole (driven by the sell-side), and as a result the natural tendency of prices is a slow grind up. But occasionally you'll receive an informational shock, which is almost always a negative, and the price of a stock or the overall market will take a sharp, punctuated decline. The hardest decision for a short seller is what to do when you get this punctuated decline. Do you cover the short, pocket a modest gain, and look to re-establish the position once it grinds higher, as it typically does? Or do you press the short on this informational validation for your original negative thesis? It's an entirely different mindset than that of most long-only investors, who - because they have the luxury of both time and informational flow on their side - not only tend to add to their positions when the stock is working (my thesis is right, and I'm raising my target price!), but also tend to add when it's not working (my thesis is right, and this stock is on sale!).

Solving the short seller's dilemma requires answering one simple question: is the story broken? Is the informational shock sufficient to force long-only investors to doubt not just their facts, but - much more crucially - their beliefs, thus turning them into sellers, too? The facts of the informational shock are almost immaterial in resolving the short seller's dilemma. Your personal beliefs about those facts are certainly immaterial. The only thing that matters is whether or not the river of information coming out of the sell-side has shifted course in a way that swamps the old belief structures and establishes new common knowledge.

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