The Investment Scientist

Before I tell the story, let’s get a few concepts clear.

Short Sell (short) means selling shares you don’t actually own. Instead, you borrow them from the brokerage to sell, but you have to buy them back at some point in the future, hopefully at a lower price, to pay back the brokerage shares you owe. To guarantee that you have the money to buy back shares you owe at all times, the brokerage requires you to have a maintenance margin of 130% of the value of the shorted shares to keep the position open. If you fall under the margin requirement, you will get a margin call to post additional money. Should you fail that, the brokerage will close your positions. This is done by buying shorted shares in the market using your money in the margin account. This forced action can cause a short squeeze. I will give you the definition with an actual example of GameStop (GME).

Just two weeks ago, GME was being traded at around $20. Some big hedge funds like Melvin Capital (Melvin), thought it should be worth only $5, so they began to short the stock. At one point, the short interest ratio, the number of shorted shares relative to the number of outstanding shares, was 140%. Since GME has about 70 million shares outstanding, Melvin shorted nearly 100 million shares of GME. Apparently, a portion of those shares was borrowed and sold twice.

In July of 2007, I attended a special send-off party for then Fed vice-chair Larry Meyer. As part of the program, we all listened to him spill his thoughts about the economy at the time. You can read my note titled “Larry Meyer: Diminishing Risks …” here.

He essentially saw the risk of a recession diminishing. When asked when he thought the next recession would be, his answer was “not within in the next two years.”

Shortly after his talk, the subprime mortgage company, Countrywide Financial, collapsed. Seven months later, Bear Stearns collapsed, followed in a few months by Lehman Brothers. By the end of 2008, we were already in the depths of the worst recession since the Great Depression. Larry Meyer surely did not see that coming!

In June of 2007, I wrote my first article on stock market seasonality. There I wrote that there was a rather persistent and robust stock market phenomenon that the market tended to perform well in the winter months than in the summer month. By “persistent” I meant that it lasted for decades in the US market, by “robust” I meant that the phenomenon showed up in other stock markets as well, as can be seen by this chart.