Learn Short Selling for the Recession (NIO)

short selling
  • Evidence shows that retail short seller (9% annual return) performs better than institutional short-sellers
  • The inverted yield curve correctly predicted all the recession during the last half-century
  • The manufacturing industry (durable goods), construction industry (residential construction), the financial service industry will be hit hardest by the recession
  • Had Nio Inc spent money as it did in 2018, it would only have 4.2 months before dissolving
 

Evidence shows that retail short-seller performs better than institutional short sellers: NIO analysis

“We provide the first large-scale evidence that retail short-selling predicts negative stock returns […] earning an annualized risk-adjusted return of 9% (Retail Short Selling and Stock Prices, 2016).”

Unlike investing, sometimes we anticipate that the value of stocks will decrease soon, perhaps in the next weeks or months. Short selling works like this: we buy a piece of stock from another investor, let’s say named Fred, for $100 and sell it immediately on the market. We net $100 at the moment but still owe Fred a piece of stock. Then, we wait for 2 weeks for the stock price to drop to $50 and purchase it back. We, then, simply hand the stock share back to Fred. From this transaction, we fulfilled our obligation to return a piece of stock to Fred and netted $50 in the process.

Evidence shows that retail short-sellers perform better than institutional short sellers. Retail short sellers, like you and I, have certain advantages over their institutional counterparts. As members of the retail investor community, retail short-sellers could learn which stocks attract unsophisticated retail investors. Additionally, we do not have the same obligations that institutional short sellers have, to maintain a certain inflow of cash and redemption of capital.

Data also points to the fact that unlike institutional short-sellers, retail ones are better able to predict negative returns in small stocks than in large stocks. Next, evidence suggests that retail short sellers benefit from knowledge within the retail investor community. Lastly, retail short sellers are more likely to use news surrounding earnings announcements and economic developments, and institutional investors are more like to use news generated from stock analysts. All these factors contribute to the success of retail short sellers.

The inverted yield curve correctly predicted all the recession during the last half-century

I wrote this article in anticipation of a recession that has been more and more evident. The inverted yield curve is an indicator used to predict an impending recession. It predicted 1980, 1982, 1988, 2000, 2008 recession – all the recessions during the last half-century. Normally, an inverted yield curve reflects a condition in which 2-year U.S treasury bonds have a higher yield than the 10-year Treasury bond. However, we know from finance that longer time horizons mean more risk and more risk should equal more return. So why does the reverse happen? In this case, the 10-year treasury bond is affected by stronger-than-normal demand. Simply, a lot of people are scared and putting their money into long-term investments, driving the long-term yield lower and price yield higher.

“You can imagine thousands of panicked investors fighting each other for only a couple of 10-year sellers. The sellers, here, have an advantage and charge you more and offer you less return.”

However, historical analysis shows that you typically have until 18 months until an official recession after a yield curve inversion (February 2021)

Historical analysis shows that stocks typically have up to 18 months to rally after an inversion. The inversion officially happened on August 14, 2019. Therefore, we are likely to experience a recession anytime between now and February 11, 2021. For example, the 2008 crash occurred 18 months after a yield curve inversion. During that time, the S&P posted a cumulative return of 25%. Therefore, you can still make a significant return after an inversion but beware of the risks. In a single day, on September 28, 2008, the S&P dropped 7%.

The manufacturing industry (durable goods), construction industry (residential construction), the financial service industry will be hit hard by the recession

 There is a moral dilemma that hit me when I was writing this article. On one hand, betting against American manufacturing and construction felt wrong. This is the bread and butter for millions of Americans who have families to support and who may end up losing jobs. Furthermore, we can’t just think of an economy locally anymore. For example, a recession in America would mean job loss around the world – a global recession. On the other hand, my action or your actions to bet against the market will not directly contribute to the collapse of these industries. Stock trading is a zero-sum game. We are not betting against the American people, instead, we are betting against other investors who can afford to play this game. People who shorted the financial service industry in 2008 did the same against big financial service giants. However, whatever you wish to do with this information is completely up to you.

The manufacturing industry suffered an 18.6% decline and the construction industry suffered 12.8% since its peak. Today, these industries are already suffering, specifically the Midwest manufacturing belt. New investments are declining due to trade wars and, as of September 2019, US manufacturing output declined by 1.5% since December 2018. You can expect durable goods, residential construction, and financial services industries to decline significantly. You can learn more from the BLS website here. Lastly, we will introduce a stock that should have been shorted since its inception.

Nio Inc (NIO) is fighting for its own survive right now

I wanted to share an example of a stock that should have been shorted. Nio Inc is a stock that is commonly talked about in many stock trading forums and groups. Most small investors think of Nio as the Tesla rival. However, this is far from the truth. Cashflow is important to any company. Specifically, operating cash flow is the lifeblood of any company. Unlike net income, operating cash flow is free from accounting biases such as accelerating revenue recognition, management estimates, and deferring expense recognition.

The “core” business lost $1.1 billion in 2018

Nio lost $1.1 billion in cash in 2018, $634 million in 2017, and $310 million in 2016. Negative cash flow is important because the more car the company produces the more money it loses. When you invest in a business, you invest in the “core” business segment. With Nio, the “core” business of selling cars is losing the company money.

Had Nio spent money as it did in 2018, it would only have 4.2 months before dissolving

I calculated a simple ratio here to show you that Nio is running out of money. Nio had $468 million in cash when it filed its Form 20-F, a foreign 10-K on April 2, 2019. Per its filing, we can see that it spent a total of $1.35 billion last year or $112 million per month on operating expenses (fixed costs) or the costs such as salary, rent, utility, etc. We use a simple burn out ratio (cash / operating expense per month) to determine that Nio only has 4.2 months left before it runs out of money. Since the company knew this, they took steps to reduce costs, but it is unlikely that management will be able to keep the company running like this forever. We can’t determine if the company was able to receive additional financing or a major bailout from the Chinese government.

The two most important things: (1) the ability to make money and (2) the ability to sustain operation are not seen in Nio Inc. What you want to do with this information is up to you. However, whenever the price of Nio increases, it is more likely the result of pure speculation instead of the value from a finance perspective. Today, the price of Nio Inc is only carried by its reputation as Tesla’s “rival”. The electric vehicle market in China is tough. There are dozens of major vehicle manufacturers and since the Chinese government had to cut back on subsidies in fear of creating a bubble, Nio Inc will face major challenges in the future. 

  

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