Over the past couple of years, the renowned “Big Short” trader Michaell Burry has been warning investors of an impending economic collapse, claiming that “the market is dancing on a knife’s edge” and that we could be in the middle of the the “Greatest Speculative Bubble of All Time in All Things,” as he boldly tweeted in June of 2021.
At the time, nobody seemed to pay much attention, with both his critics and followers proclaiming that he was being unnecessarily pessimistic by placing too much weight on the events affecting the economic climate. However, with global markets hitting all-time highs amid a severe and often out-of-control global pandemic, it seems as though erring on the side of caution would have proven to be the correct play – and this is without factoring in the hyperinflation that seemed to be looming on the horizon, even as far back as early 2020.
The rise of the short sellers
As per the recent Pulse report released by trading and investing platform Capital.com, a whopping 38% of traders across the platform opened a short position within the second quarter of 2022. This was a huge increase (34%) over the previous quarter and signified the largest number of shorters on the platform since Q1 2020, which is when the outbreak of Covid-19 first began.
Before we get into the reasoning for this increase and what it implies, it’s worth noting that shorting is a far more sophisticated trading activity than simply purchasing and holding a stock. This is because shorting involves borrowing security, selling it on the open market, and then hoping to buy it back later at a reduced price. As a result, shorting necessitates a more sophisticated understanding of trading tools and financial instruments since, if done incorrectly, traders can end up with major losses and even liquidation owing to the usage of leveraged assets.
As David Jones, Chief Market Strategist of Capital.com, states, retail investors are generally hesitant to short stocks.
“As a general rule, self-directed traders and investors seldom short-sell. They are so used to buying first and selling later that it’s psychologically very difficult for them to come out of this way of thinking. Our findings show there has been a sharp rise in clients short-selling in Q2, which shows just how significant the drop in many markets has been. This may have forced many retail traders to change their mindset.”
The Pulse report also revealed that short selling (32.1%) was more profitable than buying long (28.7%), suggesting that traders who were savvy enough to bet against the market were handsomely rewarded.
Shorting as a strategy against a market decline
At this point, it appears as though the writing is on the wall for the global markets. In other words, it will take a minor miracle for us to avoid a harsh recession, which many experts believe to be imminent in the coming months (although it is certainly not a foregone conclusion). As they say, it’s always best to prepare for the worst and hope for the best, which is why we have put together a few options for navigating the markets during economic downturns:
Traders can make immediate profits from a market downturn by shorting the stocks they believe will be hit the hardest. During a recession, the sectors typically suffer most are retail, restaurants, hotels, automotive, sports, real estate, and luxury items. In general, anything that is not considered a necessity tends to see a marked decline in demand. You can also look for highly leveraged companies or speculative stocks with little intrinsic value.
Buying the dip
Buying the dip, or dollar cost averaging, is the process of buying more of a stock that you are already invested in as the price continues to fall. As you do this, your overall entry price reduces. The whole idea behind this method is that once the market recovers, you will eventually end up in a better position than you were before since you will have been able to pick up more shares at a discounted rate. However, this method can get risky if the market does not recover quickly. In fact, David Jones believes the failure of the buy the dip strategy to be one of the primary reasons why many looked to short the market as an alternative.
“Buying the dips was a very profitable strategy through much of 2021 – but it has of course been a different story this year with the NASDAQ 100 under pressure for much of the year so far. The index had a strong bounceback towards the end of March – but once again this rally hit the buffers, and the index lost 22% in the second quarter. Perhaps those traders who had been trying to buy the dip in the first quarter – and getting their fingers burnt – decided to throw in the towel and join the short sellers in the second quarter. The NASDAQ 100 did show the tentative signs of trying to form a base during June which should make for an interesting third quarter as the battle between the bulls and bears continues,” said Jones.
That said, if you want to buy the dip, then look for companies with strong balance sheets or at least target companies present in recession-resistant industries, such as groceries, cosmetics, alcohol and tobacco, and healthcare.
Keep hold and make a post-recession strategy
Recessions do not last forever. It’s important to remember this when everyone around you panics and sells their portfolio for a loss. If you don’t want to day-trade or short the market, then it may be wiser to sit this one out and wait for things to return to normal. While not buying the dip may mean you miss out on making some extra gains, the reward is that you can keep some peace of mind in knowing that you are not overexposed to market volatility, and you can simply postpone your investing strategy to a later date.