Short People

Guess where the easy money’s being made on Wall Street this year? On the side that had been pretty much forgotten about in the past decade of awesome prosperity: the short side. That’s right, betting against stocks and ringing the register when they get blown out of the water has become the most lucrative endeavor downtown, far surpassing buying and holding stocks or flipping once red-hot initial public offerings.

And it’s about time. Nothing is more fun, more rewarding, or more challenging than spotting a short, a company that is too high and deserves to trade lower, and then profiting from it. In the hallowed tradition of hedge funds, short selling is the ticket to wealth. It is the thinking man’s game that requires you to be a sleuth, a skeptic, and a nonbeliever. People have always been able to make money betting against equities. In the great bear raids before the creation of the Securities and Exchange Commission, speculators preyed on whole industries, driving stocks down with whispers and rumors and raw sell orders. Short selling was such a successful game at one time that the government created rules to make it tougher on speculators. You are no longer allowed to buy a stock and bang it down mercilessly to foment panic. You have to wait until real sellers materialize.

But it is not the rules of the game that determine the profits; it is the fundamentals, and for the first time during this great new revolutionary era of on-line trading, do-it-yourself investing, and widespread individual ownership of stock, the fundamentals have turned south. The Federal Reserve, in its desire to stomp inflation, has raised rates to the point where business is faltering throughout the country. And when the results come in for the second quarter, we think, the disappointments will be evident in a host of industries, from retail to autos, from wood to chemicals, and from industrial to financial companies. The stock market of late has become excited about the “soft landing” that the Feds are trying to engineer, to bring the economy back to a slower, steadier growth with lower inflation. But that means that many companies that had been thinking we were in for boom times have simply gotten it wrong. There is too much inventory and too little demand. Prices have to come down, and all of those beautiful earnings estimates they made to Wall Street at the beginning of the year, when the Fed was still accommodating, will turn out to be pie in the sky. The disappointments will cause stocks in these industries to fall, since money managers are never forgiving of companies that miss estimates, no matter what the excuse.

Can you profit from the short side in the home game? Do you have to be a pro to bet against stocks? I don’t think so. I learned the game from my wife, Karen, an inveterate short seller from our dating days, when she worked at the legendary short-selling firm Steinhardt Partners, in the eighties. She coined money on the short side during two slowdowns similar to this one, the 1990 and 1994 economic declines. How did she do it? First, she recognized that you had to go after popular companies that were on everybody’s buy list. You had to go after the favorites, betting that some analyst would break ranks and downgrade a stock from a buy to a hold. She studiously avoided betting against companies nobody cared for to begin with. Second, she wanted a short to have some economic sensitivity. Drug and food companies don’t get hit by a recession; companies that sell lumber and windows and cars do. Third, she looked for companies with suspicious accounting that should have been doing worse than they were saying. Fourth, and most important, she never shorted companies that, logically, could get takeover bids, because you will be squeezed up and out by rumors. With those rules, you won’t go wrong.

Shorting, however, can be incredibly dangerous, because if you pick a stock and nothing goes wrong, you can lose a fortune. Fourteen years ago, I got it into my head to short Noxell, the shaving-cream-and-makeup company that, at the time, was independent and growing like wildfire. I had heard of a potential sales slowdown, and thought I could clean up from a shortfall. I started my short at $50, selling 10,000 shares at each point up, but in less than a week’s time the stock had jumped 8 points. As the stock climbed, the pain became intolerable as visions of a “short squeeze,” where buyers gang up on the short sellers, corrupted my thoughts. Each point up brought with it a sense of embarrassment and loss unequaled by long-side pain.

How wrong could I be? I doubled down at $58, selling short 100,000 more shares at one level. Two days later, the stock vaulted to $63. I could barely think. I searched everywhere for answers about how I could be so wrong. Was there a new shaving cream coming? A new makeup line? Had someone heard something I didn’t about improved business prospects? I began to call friends and acquaintances in the business, desperate for information. But no one knew a thing.

Finally, when I could take the pain no longer, I called my then fiancée, Karen, and asked her if she had heard anything about the ramp in Noxell. I asked her to check with friends who ran the major over-the-counter desks on Wall Street. I will never forget the answer she came back with: “Some little hedge fund’s been shorting the hell out of it, and now OTC guys are spreading word that P&G’s going to bid $90 for it. He’s got to capitulate.They’re gonna put the little guy out of business by forcing him to cover. Get on board.”

The little hedge-fund guy was me. I immediately bought 250,000 shares, reaching as high as $69 for it. The pain of the short was extinguished; the loss remains one of the biggest of my career. Sure enough, a few years later P&G bought Noxell, but it didn’t pay much more than I did in my panic cover.

I had violated all of the cardinal rules. I had shorted a potential takeover name with no economic sensitivity and solid accounting. “You deserve the pain,” my wife, known by the time of her retirement as the Trading Goddess, explained. Right now, the pain on the short side is virtually nonexistent. There are so many companies stumbling, but don’t overstay your welcome. One day, the Fed will realize just how slow the economy has become and will no longer be the enemy of the stock market. And the long side will rule again.

James J. Cramer is manager of a hedge fund and co-founder of His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer’s writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites comments at
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Short People