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The Horrible Terrible No Good Week for the Bears (Really!)

No, I’m not kidding. Last week, one of the worst on record for the stock market, was a pretty bad week for the bears.

“How can this be?”, you wonder. Based on one glance of your IRA balance last Friday, you would imagine bearish short sellers would be raising a glass in celebration. Short-sellers, who make bets against stocks, collect their profits when stock prices drop.

Yet this is not entirely true. While some bearish bets likely generated heady gains, it wasn’t easy street for the bears.

The basic math is that a short-seller sells a stock at $100 for example. He does not own this stock already, but has in fact, “borrowed” it from someone who does. If the stock drops to $80, he might buy it back and collect a $20 profit. If it rises, he loses that amount.

So, it makes sense that one would think those bearish on the stock market would have made a bundle of money last week when the S&P 500 fell 5%.

But there are two problems with that assumption.

The first is that many stocks with high short interest ROSE last week. Short interest in a stock can be measured two ways. One is the percent of shares out that are sold short. The other is to compare the number of days short to the volume of shares traded each day.

A high reading for either measure can wreak havoc in a bear’s portfolio during volatile times.

Take Snap (NSDQ: SNAP), for example. The social media company with the cute ghost logo reported earnings (or rather losses) last week. The heavily shorted stock rose almost 40%.

Snap is one of the worst performing IPOs of 2017. The deal priced at $17 per share in March and the stock promptly fell to a low of $12 in August. But last week, on the heels of its earnings release and during one of the worst market routs in recent history, it rocketed upward.

There are 118 million shares of Snap sold short, up from 35 million last spring. Short sellers likely focused on the fact that Snap’s losses doubled despite revenue increasing 72%. The social media service added 8 million users in the quarter, but ad prices fell 70%.

The bulls pointed to a better than hoped for user count. This one bullish metric was enough to propel the stock higher.

Bears also licked their wounds on other heavily shorted stocks. Blue Apron (NSDQ: APRN) rose 9% on the week. GNC Holdings (NSDQ: GNC), with almost 40% of its shares sold short, barely budged while the rest of the market melted.

What gives? It doesn’t make a whole lot of sense that heavily shorted stocks are given a free pass in soft markets. Yet that is exactly what happens sometimes.

Many funds with short exposure are judged by how much “alpha” they produce. Alpha is a fancy term that measures how much you performed better than the market. After all, if the market is up 20% but your fund is up just 15%, you’re not doing a great job.

For anyone with short exposure, your alpha is measured as the inverse of the market. For example, if your short positions did not gain at least 5% when the market dropped 5%, you’re not cutting it.

Not producing enough alpha over a longer period can result in withdrawals from your fund. Just like a smaller investor might trade out of a mutual fund that is not performing as well as the market, large investors vote with their wallets when performance lags.

So, when the market melts down like it did in the last few weeks, funds are watching their short positions closer than ever. Any position that isn’t holding its weight might be covered quickly.

Another scenario is any fund with major withdrawals must close out long and short positions to fund that departing money. Large buyers in highly shorted stocks can fuel more buying, often known as a short squeeze.

So, while many market pundits like to spin the story that the bears love a down market, this is not entirely true. Most “bears” have significant long positions as well and are losing money in those positions during a market wash out.

A more apt description is that the bears love a rational market. Stocks with strong fundamentals rise and those with broken numbers fall. The past few months have been eternally forgiving for stocks with problems, but that kindness may be disappearing.

At Profit Catalyst Alert, I offer bullish and bearish trade ideas. I’ve been watching and waiting for some reason to creep into the market to dust off some bearish ideas.

While last week stung both the bulls and the bears, I think a saner market will offer a pot of honey for those hungry bears.

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