January 2, 2013

A Short Story

Happy New Year! Boy, where to begin. With the Fiscal Cliff arrayed theatrically as the curtain rises on 2013, it’s a crapshoot picking what to write in the program notes.

So we’ll take aggressive short sellers. No, we don’t mean market Sentiment favors shorts. As December concluded, Sentiment Indicators for 15 client stocks comprising a market sample included two Negatives, three Positives and ten Neutrals. If it were a political poll, the data show your candidate ahead slightly.

Plus, the dollar is about where it started 2012. The Dow 30 were up 7%. Last year’s Gross Domestic Product (the sum of personal consumption, private investment, net exports and government consumption) likely rose about 2%, while the money supply was up 6%, meaning consumption will cost more, which means 2013 GDP, 92% dependent on personal and government consumption, has a good shot at rising.

So things look good if you don’t scrutinize economic structure (if money in circulation is rising faster than output, growth is a bit of a pyramid scheme).

Which brings us to our short story. Did you hear about Herbalife? Activist William Ackman of Pershing Square, not typically a guy who shorts stocks (borrows and sells them in hopes price declines so shares may be returned at a lower cost, producing a gain), targeted the NYSE-listed network-marketing purveyor of supplements with a public attack precisely as monthly options expirations and quarterly index rebalances were occurring December 19-21.

Ackman called the firm’s sales-recognition practices a pyramid scheme. We can’t assess the merits of his argument. But we want to begin 2013 with a lesson on structure – of the market.

Look around at noteworthy “short attacks,” we’ll call them. Often they happen during monthly options-expirations. Maybe it’s planned, maybe not, but the effect is simple to understand. Big money doesn’t invest today so much as it manages assets and risk.

Think of it this way. Suppose the amount and cost of your homeowners’ insurance were as vital each month as paying your mortgage. Say your policy was due for renewal and the day before your insurer was to decide your rate it received a letter alleging that your house was riven with bare electrical wire.

The claim need not have merit for the cost of insurance to soar, which varies inversely with your home’s value. That can happen in equities. Plus, the biggest trading intermediaries are the same firms providing “insurance” through derivatives, swaps and other mechanisms.

It’s why you should avoid reporting results during options-expirations (see our IR Planning Calendar). You’re not informing investors so much as changing the cost of insurance for everyone. Thus, the best time for short sellers to attack is right when insurance policies come due.

Plus, the stock market is a pyramid scheme of sorts, dependent on something that doesn’t exist. There is no buyer for every seller. There are five, twenty or a hundred intermediaries, each with a slightly different price. None want to buy or sell shares (by which we mean “settle” them) but simply to move them around.

Think that’s unfair? Take it up with regulators. By SEC rule, all trades must match at the best national price and all quotes that want to be the best quotes must be automated. Who does both the most? Those moving shares around. Not your holders.

Add it up. Parties that don’t want to own your shares are setting your price. Many are the same parties providing insurance and don’t want exposure to claims. And that’s how a short attack hurts price (until the insurers gang up and counterattack).

How to counter big declines resulting from sudden insurance uncertainty? Clear up uncertainty. Target money with the same aggressive sophistication as the money harming you (insurers will switch allegiance).

Remember, markets are about assets and insurance. Work from the IR chair to keep them aligned, and you’ll limit opportunity for opportunists.

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