The stock market is so unsustainably hot right now, even the short sellers have given up

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Skeptics on Wall Street have disappeared.

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As the stock market surged to a record low – regardless of recession, pandemic or warnings of a dangerous bubble – activity has plummeted to a nearly two-decade low for traders known as short sellers, who make their money. Are betting stocks will fall.

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It almost doesn’t make anyone sad. From small investors to members of Congress, critics paint short sellers as traders of pain. People around the world celebrated earlier this year when GameStop’s stock suddenly took a higher hit, causing billions of dollars in losses for short sellers. Many called it a long-standing deficiency.

But academics and short sellers themselves say they provide an important service appropriate for the moment: pushing back against stock prices that are moving too high, too fast. Despite the pace of the economic recovery and concerns about high inflation, the S&P 500 has hit an all-time high of 65 so far this year, the latest coming Monday.

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Some critics say the stock appears overly expensive, with some broad measures of value near historical highs. Fewer short sellers in the market mean there is less downside selling pressure on those prices. It could also mean fewer investors looking for overvalued stocks or being scammed.

“It’s the thing that short sellers do, they lean against the wind,” said Charles Jones, a finance professor at Columbia University’s business school who has researched short selling. “If you have short sellers who aren’t afraid to do that, you won’t get too high or too low, which I think is what we want when we’re allocating capital.”

For example, Jones’ research on Wall Street in the late 1920s and early 1930s looked at a group of stocks that were notably the least expensive, which discouraged short sellers from targeting them. . They yielded 1 percent to 2 percent lower per month than other stocks of similar size, suggesting they were overvalued.

look | How does short selling work?

When investors short a stock, they borrow the shares from someone else and sell them. Later, if the stock falls short of the seller’s expectation, they can buy the shares, return them to the lender, and pocket the difference in price.

It is therefore no surprise that short sellers are routinely blamed for artificially lowering stock prices. During the 2008 financial crisis, a few days after the collapse of Lehman Brothers, US regulators temporarily banned the shortfall of financial stocks, fearing that short sellers would undermine the already weak trust in them and the system. But will trigger a run.

Nearly four years later, however, a study by New York Fed economists and Notre Dame professors suggested that the embargo did little to slow the decline in bank stocks, which fell anyway. The sanctions also increased trading for bank shares, raising trading costs in the stock and options markets by an estimated $1 billion.

Shorting activity has been decreasing since July 2008, a few months before that temporary ban. Then, it was nearly twice the strength of now, 2.61 percent of all stocks in S&P 500 companies. In August, just 1.35 percent of all S&P 500 stocks sold short, according to data compiled by FactSet.

Much of the stock market’s continued growth since 2009 has prompted investors to pull dollars out of short-selling funds, helping to thin the ranks of opponents. Why go low when everything is going up?

“You have to look at what’s causing the market to top out,” said Carson Block, founder of Muddy Waters Research and one of the industry’s best-known short-sellers. “It certainly isn’t that humanity is at our greatest of all time.”

Instead, he said a big reason is the ultralow interest rates set by the Federal Reserve to revive the economy. Those low rates have sent ripples of cash into the stock market, and critics say they are driving up prices indiscriminately and allowing weaker companies to hold on.

Block specializes in rooting out fraud, and his early wins came with China-One, a company that was once Canada’s most valuable publicly traded forestry business. The Block released a report in 2011, describing the company as a “multi-billion dollar Ponzi scheme” that quantified how much Lumber was invested in.

Its shares fell sharply as the report echoed, and the company pushed back on the allegations. But it eventually decimated an Ontario securities regulator as “one of the largest corporate frauds in Canadian history.”

Short sellers have been credited with helping to publicize financial practices in the two largest US corporate fraud cases in the early 2000s, Enron and Tyco International.

Of course, even short sellers get it wrong sometimes. Tesla was a favorite target for years, with short seller betting founder Elon Musk’s vision of the electric-vehicle company exceedingly grand. Tesla recently posted a record quarterly profit and is one of the few companies in the world that is worth $1 trillion.

Not all small investors are betting only on falling stocks.

Consider Mark Regenbaum, portfolio manager of Neuberger Berman Long Short Fund. Most mutual fund investments do well when stock prices rise, but it reserves some of its holdings for short-term short sales.

Regenbaum acknowledges the frustration that comes after identifying the least-good candidates and then watching their prices climb. The rising tide has sent nearly 90 percent of S&P 500 shares higher over the past year. But he said he still believes shorting certain stocks can help the fund manage its risk and offer stable returns during turbulent markets.

“Everyone thinks of shorting as this element of speculation and making absolute returns, as opposed to hedging things and offering a smooth ride for the underlying investors,” he said.

Doug Ramsey, chief investment officer at Leuthold Group, says that the average stock in the market recently looked more expensive than it was at the height of the 2000 dot-com bubble based on a number of measures. The Leuthold Grizzly Short Fund has nearly halved in size in three years, reducing to US$51.3 million in assets at the end of June.

Ramsey said that after the Federal Reserve withdraws support for the markets, the stock’s performance between good companies and bad ones could once again diverge, offering better rewards for short sellers.

Small sellers need help. According to Morningstar, the average stock mutual fund that reserves some of its portfolio for shorting has delivered a 7.2 percent annualized return over the past five years, less than half that of an S&P 500 fund. The difference from year to year can be even greater. Consider 2013, when the S&P 500 returned 32.4 percent. According to research firm HFR, hedge funds with a bias for shorting lost 18.6 percent that year.

But the Fed announced earlier this month that it was cutting back on monthly purchases of bonds. Many investors expect it to start raising short-term interest rates, which will be a more significant move next year.

Block, Muddy Waters’ activist short seller, who occasionally disputes with his critics and haters on Twitter, said he’s not looking forward to quitting. At least, as long as he thinks he sees the economy and markets being mismanaged by people he sees as fraudsters.

“I think it’s the right thing for me,” he said. “It’s a way of trying to monetize my constant state of alarm, my constant state of dissatisfaction over the dystopia that is manifesting around us.”

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