Inefficient Markets, Seth Klarnan, Liar's Poker and Shorting

One of my favourite quotes from Liar's Poker was "you have to be smart to get rich trading bonds, but you have to be fucking smart to get rich trading equities" (may not be the exact wording but that's the basic idea). And it seems to me that this could still hold through today - equities are surely the most followed asset class with an enormous amount of brainpower and resources applied to making money from it. Basically it seems to me as though equities (at least large cap US stocks) are a highly efficient market and any attempt to earn abnormal returns would be difficult in the extreme

Yet going through "Margin of Safety" by Seth Klarnan, I came across this:
"Investors must never forget that Wall Street has a strong bullish bias....Accordingly, market regulators have devised certain stock market rules that have the effect of exacerbating the upward bias of Wall Streeters"

So my question is this. Mr Klarnan - and surely many others - claim that there is an inherent bias towards optimism in stock markets. It also seems as though there are very few funds that are net short relative to funds that are net long. Does this present an opportunity for the investor who is willing to be short over a prolonged period of time?

 
Best Response

So what I understand from Liar's Poker is that if you approach markets from a fundamental or technical standpoint, it is extremely hard to squeeze out any sort of arbitrage.

However I believe what Klarman is getting at is there is a human irrationality factor to the markets that can be taken advantage of. I would argue we are not only irrationally optimistic, but also irrationally pessimistic depending on the situation.

I wouldn't try and short the markets. You'll probably get squeezed before you'll see a market downturn, if there even is one on the horizon. I would actually argue US markets will continue to rally in the face of shaky fundamentals as it looks like the most stable option compared to pretty much every other global region.

 

As long as the federal reserve sees its mandate (or at least acts as if) its mandate is to prop up markets it would be a poor strategy to short the broader market in the near to medium term.

Also, hedge funds are typically net long given the fact that management teams don't like to meet with funds that are net short. Same reasoning goes for research analysts -- the majority of which -- rarely have sell options on the companies they cover so as to avoid poor relationships with the management teams they meet with and can give clients access to thus creating their competitive advantage in a super crowded part of Wall Street.

"Well, you know, I was a human being before I became a businessman." -- George Soros
 

being short long term is a terrible idea, markets go up over time. many of those guys reflect their bearishness by carrying high levels of cash (tweedy browne carries 10-20% at all times in 40 act funds, klarman as high as 50%, etc). sure, they may short every now and again, but shorting requires you to be right twice: on your thesis AND on your timing.

if you're a value guy, here's my advice: own nothing but stocks & cash at all times. stocks because you never want to miss out on returns, cash to scoop up fallen angels (and because bonds are overvalued), and don't ever short. sure, julian robertson and joel greeblatt made their careers on being long & short, but most investors aren't that skilled.

 

Interesting point on using cash to express your bearishness. I agree with you on the timing too, you really need to have a catalyst in mind when entering into a short position.

Reading the comments above I feel as though I might have not have been clear. I'm not suggesting shorting the broader market (or any index) over the long term. What I was getting at is that the inherent optimistic bias in markets may present opportunities for superior (risk-adjusted) returns in particular stocks over whatever period of time - be that 2 months or 2 years.

I have very little investing experience myself so if somebody tells me it's the biggest piece of crap they've ever heard, happy to accept that.

 

The idea that you have about "optimism" bias isn't crap. However, one thing you have to always remember about the mkts is the following: there is never just one single narrative. There are always many things going on, which means that looking at a standalone factor in the context of "all else being equal" is only the first step. Once you've done that, you need to assess the relative significance of the factor in question wrt to all the other things going on at the same time.

More specifically, in the case of markets, I can think of two considerations which you need to take into account (even leaving aside the Central Bank acrobatics, which are currently all the rage). Namely, population growth and productivity improvements.

 

As others have mentioned, being short the market in the long run is a stupid idea, mainly because you are just buying insurance against the market going down, and the people who are willing to carry this risk reap the equity risk premia, which is reflected in the positive upward trend of the stock market over the long run.

However, being short single names is not bad in itself, and even being short the aggregate market isn't that bad - as long as you balance out those positions with offsetting long positions, which is more or less the idea behind the most basic L/S thesis you can have, for example you think Apple is going to outperform the market so you short S&P500 and buy Apple. Hence shorting doesn't necessarily have to mean you look to profit from you shorts itself - as long as your shorts do worse than your longs, you are making money.

Looking to profit of the shorts themselves, which seems to be what you are looking for here, is a tricky business as others have mentioned. You can lose well over 100% if you insist on holding on to your shorts even if they are going up, whereas you can never lose more than 100% if you are long. It might also make sense to think how you actually want to express your view, i.e. you can also be short by buying put options where your downside is always limited.

 

am i the only one who saw that Klarman is spelled wrong?

You killed the Greece spread goes up, spread goes down, from Wall Street they all play like a freak, Goldman Sachs 'o beat.
 

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