“Markets can remain irrational longer than most investors can remain solvent.”
― A. Gary Shilling
According to Quote Investigator, this little tidbit came from a financial analyst by the name of A. Gary Shilling sometime in the 80s. The reason my friend employed this adage was to warn the other that, even if he is completely convinced that NVDA is overpriced and due for a correction, it may be a long while before any such correction could come to fruition. A speculator could lose their shirt while waiting for the broader market to come around to their way of thinking. Ultimately, this newsletter isn’t about NVDA and whether it is priced appropriately. However, this quote has been rattling around in my brain lately as I read headlines about the incredible run-up in certain securities, the return of meme coins and other speculative digital assets, a flash crash in Bitcoin, and the like. This one quote can lead to an interesting discussion of historical price action in markets and why almost every one of our articles ends with some form of the notion to tune out the noise of short-term market moves and keep a long-term perspective.
What is short selling?
Let’s say an investor wanted to short sell a stock. What does that mean and how does one do it? Shorting a stock essentially means betting on the price of that security going down instead of up. Most investors take a “long” position meaning they buy shares of a stock and hold them with the expectation that the underlying business activities of the company that issued the stock will create economic value which will translate to an increase in the stock price and the investor will be able to sell the stock at a higher price in the future. To take a “short” position is less an investment and more a speculative play in which the speculator essentially owns negative shares of a stock.
If a speculator wants to take a short position in a stock, they may borrow shares of a stock from an investor (or brokerage house) and then sell those borrowed shares with the hopes the price will fall and the speculator can buy back these shares at a lower price before the lender asks for their shares back. The difference between the price at which the shares were sold and the price at which they were bought back is the speculator’s profit. For instance, if 100 shares of ABC stock are borrowed and then sold at $100 per share, the short seller just made $10,000 on the sale. However, they still have an obligation to return 100 shares of ABC stock to the lender, so their profit isn’t locked in yet. Let’s say the stock price then falls to $85 per share and the short seller buys back 100 shares on the open market paying $8,500. The short seller then gives the 100 shares of ABC back to the lender and pockets the $1,500 difference. It’s a risky play because shares will only be lent for so long and the borrower will eventually have their loan called due. This means the hoped-for negative price action must happen in a short period of time. Further, the price can only go down to zero, so the profit potential is limited. In our example the most the speculator could make is $10,000. But if that stock price went up to $250 per share and the lender asked for their 100 shares back, the short seller then needs to pay $25,000 for those 100 shares and is out $15,000. Theoretically stock prices can go up infinitely making the potential loss of short selling technically infinite. In practice the borrower will eventually have their loan called due (known as a margin call) and will need to return the borrowed shares or put up a lot of cash to secure the loan. In addition to potentially massive losses with limited upside, short selling requires a margin account, and borrowers are required to pay interest on borrowed shares while the loan is out. The explanation can get very complicated but suffice it to say that this is not something most individual investors undertake. Short selling is more the purview of hedge funds and institutions.
What is a put option?
Another way to try to profit from a falling stock price is with options. While there are various types of options strategies, let’s consider buying a put option. In the simplest terms a put option is a contract between two parties where the “writer” of the put option guarantees that they will buy 100 shares of ABC stock at a given price known as the “strike price”. The buyer of the put option is buying the right to have the option to force the writer to buy at that price.
Consider if ABC stock is currently trading at $110 per share and a speculator expects that price to fall. Someone else is bullish on ABC and thinks the price will only go up from here, but they want to make a little money, so they write a put option promising to buy 100 shares of ABC at $100 per share. The speculator doesn’t currently own any shares of ABC, but she buys this option contract and pays the writer $500 for the privilege. This $500 is called a premium and it’s the reason the writer is writing the option contract in the first place. Now with ABC at $110 per share there’s no reason for the speculator to execute the contract because she doesn’t own shares of ABC so there’s nothing to sell. Indeed, the writer is hoping the stock price stays high enough that the option doesn’t get executed and they get to keep their $500. However, if the price of ABC falls to $90 per share, the speculator could now buy 100 shares of ABC for $9,000 and execute the put option forcing the writer to pay her $10,000 for those shares (100 shares x the $100 per share strike price). The speculator made $1,000 on this transaction and paid a $500 premium for the contract so she’s up $500 when all is said and done. The speculator hopes the price will go down enough for her to make a profit. Unlike with short selling, the biggest loss the speculator will suffer in this scenario is the $500 premium paid for the contract. If the stock price goes up, the speculator can just let the option contract expire without executing it.
So why doesn’t everyone buy put options?
Options trading requires investors to sign an options agreement with their broker. There are also costs to trading options contracts in the form of commissions. Options trades can be confusing and risky. Aside from this additional cost and risk, the simple fact is that stock prices are increasing more often than they are decreasing. As with short selling, a put option can only be executed within a limited time frame (the life of the contract), so the speculator hoping for prices to fall needs those prices to fall fast and soon. Most days it pays to be an investor with a long position (owning positive shares of a stock) and, over the long-term, the odds are in the investor’s favor.
The trend isn’t clear day to day. Over the last 10 years the S&P 500 Index closed positive on only 54% of days. That’s a slim margin, but it adds up over time. From 1977 through the end of 2023 the S&P 500 index was positive nearly 81% of years. Betting against the market over the long term is a losing proposition, either because the speculator is paying interest and options premiums, or because the price is going up in the long run, or both. This means that betting against the market is a practice in timing the market and that is exceedingly difficult. Go ahead and give it a try yourself (there’s no money on the line in this game). Meanwhile investors may be able to buy stocks with no commissions, hold their shares with no maintenance costs, and watch their investments gain value over the years.
I have heard people say that the stock market feels like gambling to them, but I would argue that depends on how one approaches the stock market. As we have already explored, short selling is very different from buying and holding. To take the gambling metaphor literally, let’s consider games of chance in Vegas. Casino games are always tilted in favor of the house. Among popular casino games in Vegas, the very best odds are in craps in which the house has a 0-5.56% edge and blackjack in which the house has a 0.5-2% edge. If you gamble in Vegas long enough, the odds essentially guarantee the gambler will lose money. However, investing in a diversified basket of stocks over the long term has, at least so far, been in the favor of investors. In the case of Robert Shiller’s data on US stocks going back to 1872, the longer the time frame invested, the greater the probability that an investor would have had a positive return. In this data set there was not a single rolling 20 year period, and only a few 10 year periods, with a negative return for US stocks.
Of course, past performance does not guarantee future results and any single stock price could fall to zero. This data is based on a broad exposure to a basket of US stocks. However, there is a clear distinction between gambling in Vegas and investing in stocks for the long term.
But what if you did time it right?
It is absolutely possible for speculators to make money by shorting stocks. That’s why the practice is still alive today, and it makes some hedge funds a lot of money. However, it’s a risky proposition that can also cost a speculator dearly. Take for instance the story of GameStop stock (NYSE: GME) in 2021. There was a movie released about this saga last year called Dumb Money. The very short version of this story is that short selling GME became a popular bet among hedge funds and, at one point, more than 100% of the outstanding shares had been sold short. GameStop captured the hearts and minds of retail investors who bid up the price of GME creating a “short squeeze”, a scenario in which speculators with a short position face a price soaring in the wrong direction. At some point those speculators are forced to cut their losses and buy back shares at sky-high prices and staggering losses. It’s estimated that the GameStop short squeeze cost a handful of hedge funds nearly $20 billion dollars in January of 2021 with one hedge fund, Melvin Capital, suffering 49% losses on their investment portfolio and requiring a bailout from other hedge funds. It could certainly be argued that the price movement of GME was irrational and the story of GME is a unique one from a unique time in U.S. history, but even hedge funds couldn’t stay solvent long enough to ride that out.
Remember meme coins like Dogecoin and Shiba Inu from that same year? Those coins still exist, but they are far from their 2021 highs. However, a new dog-themed coin has gripped crypto speculators in 2024, a coin called dogwifhat. Since being created in January at $0.37 per coin, the price has surged to $2.61 which is roughly a 600% return. Whatever your thoughts on cryptocurrencies, would you short it?
Dogwifhat Price
To be clear, this isn’t a call that the stock market is currently irrational. Earnings have grown along with prices and there are signs that market gains are broadening out beyond mega-cap tech. However, sometimes markets are irrational and it’s prudent to study those examples and learn from the past. We focus on the long term because investing is about weighing risks against rewards and choosing the prudent path forward. We don’t short the market because we believe market timing is, in general, a losing proposition. To be sure, being a long-term investor is not without hardships and it takes fortitude to hold on through a year like 2022, but short selling may be fraught with even more hardships for most who try. As of the time of writing this article, I don’t think my friend has shorted NVDA and that’s probably for the best.
Disclosures
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