When people find out what I do for a living, the first question I typically get is, “what stock should I buy?” I typically respond with, “talk to your financial advisor”. (Kidding aside, I do always respond with, “what are your financial goals?” There are plenty of investments I like long-term…for the right investor.) 

Once we get past the niceties of getting an advisor, the typical next question, “why is the market down?” Even in up markets, I get this question whenever there’s a down day. I’d be lying if I said anything other than “more sellers than buyers.” I wrote about this previously and it justifies a revisit as markets have become more volatile.  

This year has experienced more sellers than buyers. When there are fewer buyers, stocks and bonds will experience lower prices. If I’m a motivated seller, I’m lowering my asking price just so I can get out of the investment. I know I’m not saying anything groundbreaking, but it really is that simple. If you’re holding something the market wants, then it’ll pay a premium for it. If that same thing isn’t in as much demand, the market will pay less for it. Mr. Market doesn’t care what you think your asset is worth, it’ll offer you what it’ll offer you. 

This makes long-term investors seem powerless, but they aren’t. Regardless of what Mr. Market offers for your assets, you don’t have to sell. You don’t have to pay attention to his offer. You won’t hurt his feelings or scare him off. He’ll come around the next day and make another offer. 

Mr. Market’s offers don’t exclusively involve buying your assets. Simultaneously, he offers to sell you assets of your choosing. You can buy whatever you want at his stated price. If you don’t like the price that’s offered, you can turn him down or simply ignore him. Again, no feelings are hurt.

So why does Mr. Market have so much power over our emotions? If he suddenly comes and offers a much lower price on your stocks, you suddenly think something is wrong. Will he come back and offer an even lower price on my stock? He always will. Sometimes, he comes back and offers a much higher price but you don’t feel as good compared to how bad it felt when the low offer was made. 

Silly metaphors aside. The market moves when there’s an imbalance of buyers versus sellers. That’s it. Media coverage is a commentary on past events with no predictive power of the future. There are trillions of dollars in motion, there’s absolutely no waiting for CNBC to flash “breaking news” across your screen. Those talking heads predicting “doom and gloom” or “now is the time to buy” are right about half the time. 

Doomsayers tend to crow about a market crash every year until a crash finally hits. A broken clock is right twice a day. But they’ve been right so far this year. There has been downward pressure on stock prices because there are more sellers than buyers. 

Unpacking selling activity

There are a few ways to sell stock and certain investors don’t even need to own the stock they’re selling. Investors who own a stock will sell if they have a better opportunity or if they think the price of the stock will go down in the future. Depending on the breadth of the market, the seller will be able to find a willing buyer. Typically, investors make money by buying low and selling high. 

Short sellers do the same thing but in a different order. They sell high and then buy low. To sell a stock short, an investor needs to borrow (for a fee) shares of a stock, which are then sold. The key word is borrow. The seller here doesn’t own any shares so those shares need to be returned eventually. The seller can close out their position by buying new shares in the market to return back to the lender. This can be very expensive because, in addition to the borrowing fee, the seller could be paying a higher price to buy back the borrowed shares. 

Short sellers make money when the borrowed shares go down in price, making it cheaper to buy back. They benefit from bad news, sometimes generated by the short seller themselves. Their interests lie in the stock price going down.

A scenario where short sellers lose is when the stock price moves up, so they’ll want to get out before any rallies occur. The stock market in general is biased upwards with new money, buybacks, dividend reinvestments, growing profits, and shifting investments - all adding more money over time. Short sellers don’t win in the long run, and they know it. Contrary to where this year has gone, stocks do go up in the medium to long run. 

Since short sellers benefit from down markets, they’ll want to lock in their profits while the market is still down. Buying activity typically follows big down days and short sellers closing out their short positions (or short covering). Short but powerful rallies typically follow an extended period of selling because there are traditional buyers on top of all the short covering. More buyers than sellers. 

Short sellers closing out their positions typically spark rallies because they aren’t coordinated. If one short seller buys enough, it’ll create a domino effect where the next short seller needs to close their position before profits are erased. The buying continues as more and more short sellers close by buying. The most profitable trades tend to close out when there is peak bad news. 

Investors who buy inverse funds or put options have a similar underlying effect. These products benefit from down markets and the underlying action is a form of selling. Directly or indirectly, these funds and option sellers need to purchase (or sell) protection as investors funnel money into the investments. These investments have become more popular as the market sold off. Like short selling, these investments are expensive and aren’t meant to be held long term. 

Any hint of good news can spark a coiled spring. Any short or inverse positions will be reduced, which requires buying. In some of these cases, there’s forced buying. That day will come because markets don’t perpetually stay low forever. 

DISCLOSURES: 

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

The use of short selling entails a high degree of risk, may increase potential losses and is not suitable for all investors. Please assess your financial circumstances and risk tolerance prior to short selling.