Short on Facts and Long on Confusion

There comes a time in everyone’s life I suppose, whereby they wonder if they are getting old. I have found myself in this quandary. However, I now know with 100% certainty that I am indeed getting old. I know this because themes start to repeat themselves and circle the block. Nothing every really changes in finance, it just morphs into a new version for the next generation.

I am amazed at how quickly themes and conspiracy theories can take root these days. I suppose we have the internet and social media to thank for that. It seems that the more of an outlier the conspiracy is – the faster it grows. Now, none of the theories are new, they just circle the block and re invent themselves to suit the day. As of late, there is a load of talk about short selling and banks. Nothing seems to fire up the Canadian spirit more than an article about someone selling RBC or TD short. So, let’s take a look and see if we can spit some facts.

First and foremost, the things you read are my personal opinion, and should not be construed, interpreted, or perceived as investment advice – go talk to your financial planner. If you don’t have a financial planner, then give your head a shake and go get one. Short selling is a very complex dynamic, and I am going to try and break it down into some easy to digest chunks. Then I am going to show you why it isn’t the boogeyman it is made out to be.

Short selling is a mechanism whereby you sell stocks short in the stock market. When you decide to short sell a stock, you are actually banking ( no pun intended as we go further into this article ) on the stock price dropping – and profiting from that action. For todays example, I am going to pick on RBC. Why? Because RBC always picks on brokers, and makes our lives hard. As of todays close, RBC is trading at $153.13 a share. Anyone could go to the Toronto Stock Exchange and buy a share of RBC for around $153.13. However, a short seller isn’t interested in buying the stock – at least not yet. A short seller is actually going to go and borrow that share from someone today. By borrow I mean literally borrow it from another investor, a mutual fund, a pension fund, hedge fund, you name it. Any large company or investment fund that owns Royal Bank shares can loan them out. The short seller will borrow the share, and then sell it in the open market for the $153.13. If all goes according to plan, the stock will drop. Let’s say RBC pulled back to $140.00 a share, or about 8.50%. The short seller would go into the open market, purchase the share back for $140.00 and return it to the lender, and pocket the difference ( $153.13 sold for – the $140.00 to buy it back = a profit of $13.13 ). Pretty simple, right? Well, things get complicated quickly when you start short selling. First of all, Canadian banks are hard to sell short because they have a pretty hefty dividend attached. RBC pays out a dividend of $5.68 a year, or about 3.60%. Now, when you are short a stock, you are responsible for covering that dividend since you borrowed the stock. Let’s make sure the everyone is following the math here….. $153.13 is what I sold the borrowed share for. Lets say I owned the stock on Wednesday of this week. RBC paid a quarterly dividend on Thursday of $1.42. So, Right away the stock would have to drop from $153.13 down to $151.71 just for me to break even on my trade. Obviously every quarter that ticks on the stock has to drop lower and lower and lower just for me to break even on my trade. The higher the dividend, the higher my risk in the stock.

Another risk is that my thesis is wrong, and the bank stock goes up. Holy shit can I get in trouble quick. Using my $153.13 purchase price, lets say the stock goes up to $165.00. Well, if it did that in 3 months, and a dividend got paid, I sold the stock for $153.13, then I had to pay a dividend payment of $1.42, and then I have to buy the stock back at $165.00. That means I lose $13.29 per share. Imagine how much of an investment genius you will feel like when you lose money in a rising market!!! When you short a stock, an ETF, a market index, anything really, you best be damn sure you know what you are doing. The results can be catastrophic if you don’t. Part of the issue lies with the risk reward vortex on shorting. When you short a stock, the maximum return you can make is 100%. If I buy RBC for $153.13 and the stock drops to ZERO, I made $153.13 on my bet. That is a 100% return on my money. On the flip side though, if the stock starts rising, my loss is infinite as the stock can go up and up and up and up. Wall St and Bay St are littered with the corpses of people who thought they were so smart they shorted stocks. If RBC went from $153.13 to $306.26 ,my loss would be 100%, however if it went to $459.39 a share, my loss would be 200%, and so on and so on.

Short selling is often made to be a villain of the stock market, but it is a necessary part of a functioning financial system. Short sellers are often seen as profiting on a down market, which often turns into them profiting off of despair. John Paulson made billions of dollars betting on the sub prime collapse in 2007/2008. When you make billions of dollars when a lot of people lose their homes at the same time, it doesn’t exactly warm the heart. Anyone who has watched ‘The Big Short’ knows what I am referencing here. As crass as it may be though, short sellers provide a valuable service to investors. When the short seller has borrowed the share, sold the share, and then financial apocalypse happens, the short seller must go into the market and BUY back the share to return to the original owner. That buy transaction is what puts a floor on stock prices. Short sellers tend to be buying back stock at the exact same time that emotional retail investors are selling like crazy. Short sellers actually help stock prices to find a bottom and start a new uptrend. Without short sellers to buy back in and ‘cover’ the short, there would be a lot less buyers, and prices would head lower.

Okay, so we know what short selling is, and what short selling isn’t. But, it seems to me, that a lot of people don’t understand what it represents. Canadian banks right now are seeing a lot of interest to the short side right now. RBC is 1.03% of the float sold short, TD is 2.19%, CIBC is 3.19%, BMO is 1.58% and Scotia is 2.49%. These numbers are about double where we normally see them. A lot of people want to hold Canadian banks short. Who can blame them really? Unemployment is climbing, GDP per capita is where it was 10 years ago, the Canadian economy is in the shitter, and Canadians are the most indebted in the developed world. There isn’t really a lot to get excited about here for Canadian Banks.

Now, there are a lot of talking heads, and mortgage people, and media pundits that will tell you that it is dumb to short the Canadian Banks. They will tell you a Canadian bank will always be bailed out by the government. They will go on and on and on about how sound the Canadian Banking system is. Yes, they are right. But, just because banks are sound doesn’t mean their stock price won’t go down!!! Stocks trade on a multiple of earnings. If bank earnings go down, then the stock price follows suit. People who short bank stocks aren’t thinking that RBC fucking goes belly up tomorrow. Jesus. Get a grip. Instead, a lot of analysts are thinking that if RBC puts aside a lot for loan loss reserves, and their net interest margin starts to fall ( NIM ) and they loan out less funds on mortgages, and people stop paying ridiculous bank fees when budgets get tight, and on and on, RBC might not make the insane billions it used to. So, the stock price goes down. I don’t need RBC to go out of business to make my trade profitable. I need RBC to drop by 20% ( which happens on the regular ) to profit.

Keep in mind that if you hold banks short, and the economy does suck the hind tit for a while, and the stock market goes down, then my short position goes up, and it balances out my portfolio. Below I will cover a couple reasons why people would sell short bank stock without the premise being they go bankrupt.

Diversification: Unlike the US, it is hard to short the Canadian housing market, so by shorting Canadian banks, it is a proxy on shorting Canadian housing. If someone truly feels that real estate takes a dive, shorting a bank would be a good proxy.

Taxation: Canada has one of the most oppressive tax regimes going right now, so short selling can help. Let’s say I bought my RBC stock back in March 2009. At the time, the stock was around $32.00 a share. Today it is worth $153.13 a share. That is a profit of about $121.13 a share. If I owned 10,000 shares, and sold them, I would have a capital gain of about $1,211,300.00. Since we increased capital gains tax this year, 66.6% of that gain is considered, or about $806,725.80. Now, on that, I would easily be in the top tax bracket of 53.53% ( In Ontario ) so I would owe CRA $431,840.32 in taxes!!!! Holy Shit. However, I know that even if RBC dips over the next few months, it will eventually go back up. So, I could short sell some shares so that if it dips, then I still make a little bit on the short sale, and perhaps use that new found profit to buy back more RBC shares at a lower price. I would actually grow my future net worth, and better yet, I could stick it to the tax man. Anyone that knows me will tell you I would rather chew tinfoil than give a dollar to the Canada Revenue Agency.

Hedging: Quite often professional investors will use short selling ( or more likely options – form of shorting, but way more complex ) to hedge positions in their investment book. If they own a lot of bank stock in their portfolio, they will shirt bank stock to reduce their net sector exposure. This comes in handy when reporting periods come up. For example, if I ran a hedge fund, and I had 50% of my portfolio in Canadian bank stock, and bank stocks were all over the news for getting hammered, I would really hate to send a report out to my investors saying that 2 of every 10 of their investment dollars is invested in bank stocks that are the top story on the financial pages. So, if I sell short some bank stocks that is equivalent to say, 35% of the portfolio, then magically when I report my holdings, I could say that my fund only had a 20% exposure to the Canadian banks. Since Canadian Financials represent about 31% of the TSX , I can tell my investors that I am actually a genius, and I am underweight financials because I saw it coming. Of course the truth is a lot more complicated, but people only know what they read on the quarterly report.

Pairs trade: This is a little more complicated, but the easy explanation is this: Quite often a portfolio manager will put on a pairs trade. Right now is actually a prime time to put on a pairs trade. A pairs trade is basically what it sound like, whereby your pair up a couple of stocks in the same sector. A great pairs trade right now might be CIBC and BMO. Now, BMO is so conservative they probably still have the first penny they ever earned. I mean their risk department is closed up tighter than a bulls rear during fly season. I would think that BMO would typically perform better than lot of banks, so if I had an investment mandate to be in Canadian banks, I would rather own BMO. On top of that, I think CIBC will absolutely shit the bed if Canadian real estate falters. Let’s face it – CIBC has a track record of loaning money to every problematic thing. Enron, Worldcom, Subprime, the list literally is a mile long with CIBC. I am pretty sure the risk department at CIBC was laid off in 1985, and the bank has just been winging it for the last 25+ years. So, the portfolio manager would short CIBC because they would likely suffer the most in a real estate correction. if the theory holds, BMO does a bit better than sector average, and CIBC does a lot worse than sector average, so I add the 2 gains together. It is basically arbitraging out difference in the sector. My example above on the pairs trade of Long BMO and short CIBC is also backed up by the current amount of short interest in each bank. Apparently I am not the only person thinking CIBC is a bit of a struggle bus right now.

None of those examples mean that short sellers think banks are going broke, but it does mean that there is a good chance that bank stocks will drop over the coming days, weeks, months etc. in their opinion. Just because something goes down doesn’t mean financial armageddon is coming. Of course, it gets a lot more clicks if I make the story sound like RBC is going belly up, doesn’t it? Generally I find the louder the argument the less the facts, and their seem to be an awful lot of people that are yelling and screaming about shorting Canadian Banks.

I will finish with a story so that it really drives home the point I am trying to make here. Back in 2020 when interest rates were stupidly low, I made a bet that interest rates would go up. I shorted the US 20 year bond ETF, also known as the TLT. Remember that if interest rates go up, then bond prices come down. At the time it was trading at a price of $160.00 a share, and I averaged in, and my average price was about $158.56. I knew rates had to go up ( although even I was shocked by how much). I exited my trade in October of 2023 at a price of $85.25 a share. I made a capital gain of $73.31 on the trade, minus my interest costs ( bonds pay interest, so when you are short a bond fund, you have to pay the interest distribution ). At the end of the day, and after my borrowing costs, interest cover, fees, and commissions, I walked away with about $61.50 a share. It was a great investment during a time when bonds lost money, stocks lost money, and inflation was going crazy. A couple of points to note though:

1. I didn’t sell short at the high point, so I didn’t even maximize the opportunity. I should have shorted the TLT when it was almost $15.00 higher.
2. I didn’t buy back or cover at the low point. In fact, bond prices went down almost $8.00 more from where I covered my trade.
3. Never once did I think the price was going to zero. I knew rates had to go up, so the trend was my friend, but I certainly didn’t sit in front of my computer and hope and pray for the US government bond to go to zero. I didn’t need it to go to zero for my trade to work.
4. I used the profits from my trade to level out my investment returns across my portfolio. I had a lot of positions that lost money during the period I was short the bond fund, and I used the profits from my short bond trade to buy back into stock positions that I liked. That turned out to be a great decision because those stocks have done extremely well since October 2023.

Shorting can work, shorting can be a disaster, but it certainly isn’t always one, or never the other. YES, Canadian Banks have some short interest, and YES, I feel it is warranted. But, we need to remain sound and logical in our reasoning and understand that there is a time and place for shorting. Anyone who claims that you only short Canadian Banks for financial armageddon also probably believes we didn’t land on the moon, and there was a second shooter on the grassy knoll.