I watched an interview with Steve Eisman on CNBC’s Fast Money. Steve Carell played Eisman in the movie “The Big Short” and Eisman is best known for predicting the 2008 housing crises and profiting from it. His major talking point in the interview was that bank stocks are uninvestable and the only reason someone might invest in a bank stock right now is that they are cheap. He then said, “Investing in something just because it is cheap is a value trap and shorting something just because it is expensive is a death wish.” 

Eisman is one of the most famous short investors in the past 20 years and the last part of his quote really got my attention. It led me to ask, “Why shouldn’t I short something if it is expensive? Shouldn’t the price eventually fall and normalize to the fair value?”

Sports Cars Aren’t For Everyone

Just because a stock is expensive does not mean the price will go down. Here is a used car example. 

The most expensive car on a used car lot is often the small, flashy sports car. Buyers who only care about fuel efficiency think the sports car is wildly overpriced for how inefficient its engine is. Buyers who have large families think the small sports car is extremely overpriced for how few people the car can transport for the cost. Someone who is worried primarily about safety will scoff at the high price because they will never drive the car fast and thus see no value in a car that can go fast. An Uber driver thinks the car is overpriced because they will never be able to generate enough income driving people around to justify the price. All these buyers correctly believe that the price is too high for them.

If we watch all those buyers reject the high price, we would probably conclude that the price is too high and the only way the dealer will sell it is by lowering the price. Therefore, we should bet that the price of the sports car will go down and short it, right? 

Expensive doesn’t lead to price drops

The problem with shorting the sports car is that just because the car looked expensive to me and all the other people I saw looking at it, doesn’t mean it looks expensive to everyone who looks at it. I ignored all the people who might want to buy it because it goes fast, it is small, and it is probably rare. There are enough sports car enthusiasts with deep enough pockets to not only sustain the high price but maybe even drive the price higher. 

How does this apply to stocks?

Just like how car buyers have different criteria and priorities when car shopping, investors have different criteria and priorities when stock picking. If an AI tech stock was the sports car in my analogy, then value investors will think it is expensive because it does not generate enough cash to justify its high price. Momentum investors might think that the price movements aren’t favorable for continued price increases. Dividend investors will think all stocks who don’t pay a dividend appear wildly overpriced because they don’t receive any quarterly payouts. 

But, we can’t ignore the growth investors who think that the stock might grow into a world changing monster and will pay a premium now to get in early. Those growth investors will often be enough to prop up the stock and often drive it higher. Much to the dismay of the other investors in the market.

When should I short then?

Shorting stocks is a very hard thing to do. If there was an established formula, everyone would do it. Here is the basic set-up I think you need.

You obviously need a stock to be overpriced but you also need something to change within the collective buyers that will lead them to view investment as less attractive. For example, investors buy REITs for dividend income. A good short opportunity would be identifying a REIT who will soon stop paying its dividend before the current investors do. Or, maybe, you identify a company who is misstating their sales. The price won’t fall until the current investors realize the fraud and also no longer want to own the company. If they understand the fraud and still choose to own the company, most likely the stock won’t fall much.

I hope this article was interesting. If you have a short strategy you like, let me know in the comments!