Pass the Straightjacket

Dear Reader,

There are only two reasons you would swim against the tide of prevailing wisdom.

You are so convinced you are right — and that everybody else is wrong — that you are prepared to open yourself up to ridicule for the strength of your convictions.

The other reason is much more simple…you are completely and utterly bonkers.

Leaving the second reason aside for now, it takes more than courage alone to go left when everyone else is turning right. To zig when everyone else is zagging.

If you get it right in the markets, however, it can lead to a bonanza of a payday. Pick the next stock market crash or calamity, and the potential rewards are almost incalculable.

It doesn’t have to be a big event like a crash, however, to make your money. You could be a contrarian investor who buys when everyone else is selling.

The tough part is that no matter how right and clever you are, you will never buy at the lowest point.

Instead, you will likely build up a position over months, and potentially wait years, to have your moment in the sun. Just like the contrarian funds who started buying into BHP Group Ltd [ASX:BHP] throughout 2016.

Having bounced along around $38–39 throughout the first half of 2014, BHP’s share price took a hammering. Within 18 months, it was trading just above $14.

As a constituent of just about every index and buy and hold portfolio, the pain was palpable for investors. Yet within two and a half years, BHP was back trading above $40.

That’s a massive turnaround for such a massive stock. Not to mention the money it made those contrarian funds who had the confidence to back their opinion.

Timing it right is the hard part. Those that tried to pick the bottom all the way down through 2015 had their backside handed to them on a plate.

It’s a similar challenge shorting stocks.

Some traders made their name, and a nice slice of money, shorting Enron way back in the early 2000s. Jim Chanos among them.

Chanos’ Kynikos Associates is one of the largest short-selling hedge funds in the world. His Enron short trade was the one that made him famous.

Chanos’ approach might sound simple enough. He targets companies in which he believes there is a fundamental flaw in their valuation.

In Enron’s case, it was an accounting trick that allowed them to book future (unrealised) profits as revenue, whilst also hiding losses.

They also inflated the value of many of the energy contracts they traded in. They were able to do this essentially because they were making the market. That is, constructing the quotes (both bid and offer) to determine the value of the contracts.

It was only after pouring over years of accounts with a fine toothcomb that Chanos was able to uncover the flawed accountancy practices. Nearly every broker in town had them as a ‘buy’.

But just like trying to pick the bottom, picking a top is just as hard.

The Wall Street Journal reported that Chanos entry prices for his shorts ranged between $65 and $80 — well below Enron’s eventual peak of $90.75.

What’s more, after that peak, it took 16 months for the Enron share price to finally hit zero — reputedly making Chanos’ company around a $500 million profit.

Even if you do have strong convictions and a track record, you don’t always get it right either. Even if you are Jim Chanos.

For four years, Chanos has been shorting another stock. A stock that has become the widow-maker of short sellers…Tesla.

Since its IPO in 2010, to my knowledge, Tesla has only had one profitable quarter — the third quarter of 2019. Funded by debt and discounted rights issues, from the outside it looks like a company just trying to keep the balls up in the air.

From an analyst’s perspective, the numbers don’t stack up. Apart from one profitable quarter, Tesla has lost money year after year. With each new model comes delays, cost overruns and a swag of other problems. Not to mention high turnover among its senior staff.

Yet one look at the price chart shows you how the shorters are travelling. Right now, they are dripping in blood.

Having issued shares at $17 for its IPO in 2010, Tesla’s share price is now within a whisker of $500.

Tesla — monthly share price

Money Morning

Source: eSignal

[Click to open in a new window]

Each candlestick in the above chart represents one month of trading. From 2014 to the start of 2017, the shorters must have been right many times…but just for a while.

It’s the same scenario from mid-2017 to mid-2019. Each big red candle would have seen shorters patting themselves on the back.

Yet from mid-2019, as the chart shows, it has all been one-way traffic.

Just this last week, news reports have gone mad with Tesla now being the most valuable US-listed auto stock of all time, at $85 billion. Compare that to Ford ($36 billion), and GM ($49 billion).

A quick calculation tells you that Tesla is now worth the same as Ford and GM combined. For how long? Nobody knows.

But if legendary short-seller Chanos has any short position remaining, he will no doubt be feeling the pain.

In one way, the gravity-defying Tesla (for now) reflects what is happening in the broader market. While buy and hold investors might not be about to short the market, they might be wondering if they would be better off sitting on the sidelines.

With the bull market in the US now in its 10th year, you’d have to bet that it is closer to the end than the start. Just the slightest hint of an increase in the cash rate from the most important financial institution in the world — the US Federal Reserve — has been enough to send the markets into a panic.

But after tightening from late 2016 to late 2018, the Fed lost its nerve. It tightened the cash rate four times in 2018 alone.

And then, having sat at 2.5% for the first half of 2019, it cut the rate three times before Christmas last year. Only recently, Bloomberg reported that Rabobank are predicting rates could fall to zero this year.

While that might be a long shot — especially considering the Fed said that it would likely leave rates unchanged in 2020 — we know that central banks will do what it takes to keep the global economy afloat.

And that could mean plenty of more money printing ahead. With a sea of mergers and acquisitions fuelled by cheap (as in almost no-cost) money, there might still be plenty more life left in the party.

Nobody knows the future. Over much of the last few years (if not more), it has been seen as a contrarian position to predict a market fall. However, it might just be things have changed. The new contrarians might now be the ones calling for the market to keep heading up.

All the best,

Matt Hibbard,
Editor, The Rum Rebellion

The Rum Rebellion