The key ingredients of the recent bounce in markets were created from continuing Central Bank support and short covering activities by hedge funds. World economic growth appears to be stalling at about 3% and worse across Europe. Therefore the normalisation of interest rates seems a long way off. Reported US payrolls confirmed that the US economic recovery is at a mature stage. However, current interest rate settings are not consistent with a mature point in the economic cycle. At face value, near zero interest rates would suggest a recessionary environment exists. Indeed the US is moving through a mild recovery whilst Europe and Japan splutter. Today, the level of most offshore equity markets belies the true economic cycle and the difficult outlook for company earnings. In contrast most major equity markets simply reflect the low level of interest rates and the enduring hope for even more Central Bank largesse.
In our view the current rally will peter out, the short covering will be completed and hedge funds will again reset their short positions in an effort to generate returns by forcing lower “price earnings ratios” (PERs) on the market. While we agree that equity markets will endure a period where high PERs move lower, we suspect that hedge funds will force the process to occur quicker than it should. In doing so, they will create further periods of excessive volatility that are not reflective of properly functioning capital markets. Investors and providers of patient capital will continue to be challenged by the short term focus of speculators.
Shorting in Australia
For the uninitiated, ‘shorting‘ stocks is the act of selling assets (stocks, commodities or other securities) in advance of buying them back, with the aim of making a profit when the price falls. The tracking of short positions in the Australian market has not been diligently undertaken in the past and so we cannot say whether the current level of short positions is excessive or high. However, we can review the current level of shorting, particularly in the ASX 20 stocks index, and draw the conclusion that different parts of the equity market are subjected to different pricing pressures. While the top end can and is actively shorted, the smaller end is benefiting from investment flows and no shorting. More specifically, we suggest that small and low capitalisation stocks are not subjected to shorting because stock is not lent out by the fund managers. Therefore flows into small or micro-cap managers acts to push up share prices and expand PERs. Today it is becoming increasingly common to see small-cap companies trading at much higher earnings and equity multiples than large-caps, contrary to traditional patterns and common sense. Often this is not supported by either historic or sustainable earnings growth or return on equity (ROE).
At Clime, we actively track the short positions that are being created and managed on the ASX. Whilst our focus is on the stocks that attract our investment interest, we do monitor the shorting of larger stocks in major indices. In reviewing the short positions in late September, we noted the following trends in the last 3 months of severe market weakness:
- Generally speaking, shorts continued to grow across most of the market with the ASX20 sustaining an upward trajectory of short positions. In late September, this increase was tempered somewhat in the covering of shorts in CBA as its equity issue was completed (see table).
Figure 1. ASX 20 Combined short position
Data Source. Australian Securities & Investments Commission
- Companies that have seen a significant increase in short positions in the ASX 300 over both the last few months and recent weeks included Ardent Leisure (AAD), Computershare (CPU), Dick Smith (DSH), Henderson Group (HGG), Seek Limited (SEK) and Retail Foods Group (RFG).
- Companies that saw a gradual increase in short positions over the last month included Adelaide Brighton (ABC), ANZ Bank (ANZ), BHP Limited (BHP), Brickworks (BKW), Credit Corp (CCP), CSL Limited (CSL), McMillan Shakespeare (MMS), National Bank (NAB), Origin Energy (ORG), Realestate.com (REA), Ramsay Healthcare (RHC), Westpac (WBC), Wesfarmers (WES), Westfield (WFD), Woolworths (WOW) and Cabcharge (CAB)
- Companies that saw a significant decrease in short positions over one and three months include Flexigroup (FXL), SMS Technology (SMX) and The Reject Shop (TRS). Noticeably, these shares spiralled upwards after their battering down by shorts;
- Companies that saw a significant decrease in short positions over one and three months include Flexigroup (FXL), SMS Technology (SMX) and The Reject Shop (TRS). Noticeably, these shares spiralled upwards after their battering down by shorts
- Woolworths continues to be the largest short position by value in the market, increasing week on week through September;
- Cabcharge remains the most shorted stock in the Clime investment universe and the most shorted by days to cover on the ASX (by a significant margin over no.2).
As at 30 September, the total combined value of the 30 largest short positions on the Australian share market was $17 billion (see table). These shares are borrowed from Australian and International funds. The shares lent by Australian funds are in the main shares that have been bought with the savings or capital provided by average Australians. These people are required to contribute their superannuation into funds and they have no idea what their savings are being used for or who ultimately benefits at their expense.
It is clear that the level of shorting in Australia has increased in recent months and it is our view that this has added to the decline in equity prices and the increased volatility in the Australian market. Increasing supply must cause a price decline and while we do see an argument for a decline in PERs, we are not supportive of market corrections caused by excessive shorting.
The economic benefits to the community or the economy or indeed the millions of Australian superannuation members of shorting is unproven. Certainly shorting does increase liquidity, but in our view the actual benefits seem to accrue only to a tiny minority of market participants, and these benefits are short term and rarely sustainable. For instance, whilst the shorting of Metcash has received much publicity as an example of shorting success, there are a number of shorts that simply appear excessive, have traits of market manipulation, or indeed smell of insider trading.
In conclusion and directly to the problem with short selling, followers of Clime and StocksInValue members have witnessed the remarkable recovery in the prices of the Reject Shop (TRS) and SMS Management & Technology (SMX) in the September quarter. Following a period of excessive shorting of each stock, both have seen their prices lift by over 50% as the broader market fell by over 12%. A remarkable price recovery that smacks of market abuse.
Read more on shorting – John Abernethy takes on the market ‘clowns’
Clime Asset Management (Clime) owns all stocks mentioned in this article (with the exception of REA) on behalf of various mandates where it acts as an investment manager.