introduction
Playing the stock market must be easy: When the economy is booming, buy stocks. If it gets worse, short circuit them.
Stock selection shouldn’t require much effort either – we just have to apply metrics from the factor investing literature. In bull markets which may mean specializing in low-cost, low-risk, outperforming, small, or high-quality stocks, and in bear markets it would mean the other.
Of course, investing in stocks is neither easy nor effortless in practice.
First, even economists cannot really say exactly when an economy goes from boom to bust. Economic data will not be published in real time and is revised ceaselessly. It may take quarters, if not years, to find out exactly when the tide has turned. Second, buying stocks with high factor loadings has not been a recipe for fulfillment within the recent, prolonged bull market. For example, the Goldman Sachs ActiveBeta US Large Cap Equity ETF (GSLC) – the most important Multifactor productwith nearly $11 billion in assets under management (AUM), has underperformed the S&P 500 by 10% since its launch in September 2015.
But what about short selling stocks? How has this worked as a method? Let’s explore.
Short selling stocks with bad characteristics
To determine which stocks to short, we focused on five aspects: value, quality, momentum, low volatility and growth. The first 4 of those are supported by academic research, namely It’s not the expansion factorDue to its popularity amongst investors, we included it in our evaluation.
We created and shorted five indices composed of the highest 10% of the most costly, low-quality, low-dynamic, most volatile, and lowest-growth stocks within the S&P 500. To determine whether the strategy generates excess returns, we took a protracted position within the stock market. We rebalanced our portfolios every month and added 10 basis points (bps) to simulate transaction costs.
From 2005 to 2022, shorting low-growth, low-momentum stocks delivered virtually no excess returns, while doing the identical for low-quality, high-volatility stocks produced negative returns. Betting against low-growth stocks worked well until a few yr ago, when Amazon, Meta and other high-growth firms began underperforming.
Three portfolios crashed because the stock market recovered from the worldwide financial crisis (GFC) in 2009. Why? The stock prices of Citigroup and other over-indebted and unprofitable financial firms fluctuated and were extremely volatile. But as governments and central banks stepped in to make sure these firms didn’t fail, their stock prices soared.
Excess Returns: Short selling stocks with poor characteristics
Breakdown by aspects
Although a few of these portfolios followed similar trends, the underlying portfolios were quite different.
Technology and healthcare dominated the expensive and highly volatile portfolios over the 17 years under review. Real estate stocks are often heavily indebted and are subsequently not adequately checked for quality indicators. Consumer discretionary firms made up the most important portion of our portfolio of underperforming stocks. Real estate, financial and energy stocks all showed comparatively weak sales and profit growth.
Short Selling Stocks with Poor Characteristics: A Sector Breakdown, 2005 to 2022
Correlation evaluation
Stocks with bad characteristics had certain relationships. The excess returns of low quality, low momentum, high volatility, and low growth stocks were all highly correlated. Expensive stocks had low but positive correlations with the opposite 4 portfolios.
Correlations of stocks with poor traits, 2005 to 2022
Short selling stocks with multiple bad characteristics
While high correlations between stocks with bad characteristics will not be a great sign for a portfolio consisting of stocks with multiple bad characteristics, we applied the next: intersectional model Building a portfolio of pricy stocks with low quality, high volatility, low momentum and low growth.
This portfolio had significantly different sector weightings than the S&P 500. Healthcare, technology and real estate dominated, while utilities and consumer staples were underrepresented.
Short Selling Stocks with Multiple Bad Characteristics: A Sector Breakdown, 2005 to 2022
But what about portfolios? basic and technical metrics? We compared the rankings of the highest 10 stocks in our portfolio to those of the S&P 500. Snap was the worst performer, followed by cruise firms and biotech firms.
These stocks don’t perform poorly on all metrics. For example, they recorded relatively high sales growth. Of course, the more characteristics are used when choosing stocks, the less stocks meet all the standards.
Key Metrics: Top 10 Stocks With Several Poor Attributes Compared to the S&P 500
Best rating = 100
What form of excess returns did the mix of all these features deliver within the stock selection process? We began with our expensive stock portfolio and steadily added the opposite metrics. Performance has not improved.
Short selling these stocks wouldn’t have been a great selection between 2009 and 2021although it could have worked before the worldwide financial crisis and nonetheless in 2022.
Excess Returns: Short selling stocks with multiple bad characteristics
More thoughts
Why is it so difficult to short stocks? Research by Robeco points out that factor investing primarily works on the long sideso investors can earn excess returns by buying low-cost or outperforming stocks, but not much by shorting expensive or underperforming stocks. Research by AQR believes that short selling such stocks might be profitable.
The challenge with short selling may lie within the asymmetry between earning money on the long and short sides. Losses from long positions reach a maximum of 100% because stock prices cannot change into negative. The losses on short positions, however, are theoretically infinite.
Famous short seller Jim Chanos has been shorting Tesla for years. In 2020, the electrical automobile maker’s stock had truly abysmal fundamentals and traded at an inflated valuation. Still, shares rose greater than 2,000% afterward.
Sometimes bad stocks are an incredible investment.
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