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Smart Investing In 1997; Short Theory Revisited
he skyrocketing S & P 500 (almost a 51% return in two years), has caused an increase in the number of investment theories that investors believe to be sound. As an example, consider momentum (extremely short term) investing.
But one theory -- that even securities industry professionals have accepted for years -- now is being questioned. It is the short theory, otherwise known as the "cushion theory".
Here's the question as framed to every securities professional taking his/her securities examination:
Short theory is a strategy that is:
a) Neutral;
b) Bearish; or
c) Bullish
Did you choose answer a)? If so, continue with your day job!
Did you choose answer c)? If so, congratulations! You have joined the thousands of securities professionals who chose that as the correct answer, and the many money managers who practice the strategy. That is, at least before a new MIT study.
First, some background. The short theory or the "cushion theory" posits that investors can make money by buying stocks with large, uncovered short positions (defined as shares borrowed to be sold now to another investor but not yet repurchased, betting that, later, the price of the stock will have fallen).
On the surface, the theory appears to make sense: by definition, future purchases (to cover the shorts) are guaranteed. That then provides some price support, if the stock price falls. And if the stock price rises, a "short squeeze" results (where, in scrambling to cover quickly, covering short sellers drive the rising price even higher).
Appears sound. What's the problem? MIT business school professor Paul Asquith joined with a Harvard business school student Lisa Meulbroeck to study whether heavily shorted stocks lag the market. They studied all NYSE and AMEX stocks between 1976 and 1993 (parenthetically, the S & P 500 declined 48% between 1973 and 1974).
Their conclusion? As a group, heavily shorted stocks (defined as 2.5% of total shares outstanding) indeed did lag the market, and by a large margin of 16%. Moreover, even waiting two years until after the short sellers covered, they found that the stocks trailed the market by 17%. So much for the short theory being bullish!
What do Asquith and Muelbroeck recommend? Sell, don't buy, stocks that are heavily shorted. This makes sense. But how many money managers (perhaps those managing your/your clients' money) won't see or will ignore the MIT study, risking an historical market lag of 16% to 17%?
From our perspective, Advocate Capital Management, Inc. now adds short theory purchases to our list of "Don'ts", as we analyze the stock selections of mutual funds and institutional money managers for the benefit of our clients.
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Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.
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