Carson Block gets pumped when a corporate fraud implodes.
Block is one of the best-known activist short sellers and the founder of Muddy Waters. The hedge fund publishes reports on companies that it says has misled investors, while making a bet on the stock price falling. Block made a name for himself targeting frauds in China and has more recently gone after companies in the UK.
You would think a pandemic-induced recession would create a target rich environment for short sellers, but it hasn’t. Instead, investors are binging on risk: Armchair traders have been piling into options—a derivatives market that many newbies have little understanding of. In May, Tesla CEO Elon Musk said shares of his electric car company had risen too high; the stock price has doubled since then. Mega tech companies have carried the S&P 500 Index of stocks back to levels before the Covid meltdown. A frenzy among special purpose acquisition companies (SPACs), a maneuver for bringing private companies to the public market, is gaining momentum.
In Block’s view, investors have been “anesthetized” by central banks, which have bought trillions of dollars of assets to amp up risk taking. Quartz spoke with Block about the collapse of German fintech (and short-seller target) Wirecard, the steroid hormones that intoxicate traders, and why he hates his trade ideas before they get implemented. The conversation was edited and condensed for clarity.
Quartz: Is this a good or bad time to be shorting stocks? The economy is cratering, but stocks are soaring.
Block: It’s never a good time. I’m fond of saying I hate every single trade at the moment that we put it on. You can give yourself all kinds of reasons why it’s a bad trade or a good trade.
There are more problematic companies with more market cap and liquidity than there were yesterday and, you know, two days ago.
But it’s also harder to break through. I feel like the bar has been getting raised every year, just in terms of being able to tell stories about companies that are engaging to investors and that they think matter.
There’s a lot of what I do that is somewhat similar to journalism. The more people are anesthetized to risk—which was definitely the case coming into Covid and I think we’re really back to that in spades—the more that’s the case, the more selective you have to be and the better you have to be at explaining to investors why it matters to them.
We started doing this with video because, when I started doing this in 2010, the human attention span was longer than it is in 2020. I think markedly longer. We’ve shortened up our reports for the same reason. People used to read maybe five pages of a report. I think they read five paragraphs if I’m lucky now.
So we have to adjust. On the surface it seems like it’s a very target-rich environment, but what creates that richness of targets is this numbness to risk, and so it’s harder to break through that. It’s easier to find problems that you can make an economic case for shorting, but it’s harder to message them.
It’s never a good time, and that’s why I hate every trade before we put it on.
You Tweeted recently about John Coates’s book The Hour Between Dog and Wolf, which examines the testosterone-driven mania that can drive excessive risk taking, and the cortisol-fueled hangover that can follow that. What caught your attention?
The portion that I was really referencing was the effect of testosterone. So this feedback loop where you make the trade, it’s successful, you get a rush of testosterone, make another trade but it’s bigger. It pays off and there’s another rush of testosterone.
Right now these bets are all paying off, seemingly anyway, because of central bank liquidity, and you have all this money that’s been poured into the market. The point that Coates makes, the problem becomes when you’re a trader, and you just keep winning and your body keeps getting rewarded with these testosterone rushes, is that as this process goes on you’re taking riskier bets and with less upside.
When I see certain things like Tesla going parabolic—I was reading Coates’s book at that time and I thought, yeah, I feel like this accurately describes what’s driving a lot of these names. The obvious overconfidence, and the obliviousness to things that at least used to matter, made me think of waves of testosterone coursing through the market, which is similar to what Coates describes.
Is that rush, or trading high, something you can relate to?
The book really did make me more cognizant. As an activist short seller, I wasn’t even involved in Wirecard, and when it collapsed, just because it’s vindication for what we do […] I was just so pumped. And having read Coates’s book, it made me think about the hormonal component of what drives these dealings.
I think I’ve been experiencing the cortisol downdraft as a short seller because, stuff that we’ve been short, a lot of it has been ripping. We had an amazing start to the year and we’ve given a good portion of it back. I feel like the cortisol is coursing through my staff here.
As a short seller you’re somewhat used to that because a lot of time things are going to go up for a while before they finally break and go down—if they ever break and go down. You just have to live with that. Whereas, looking at things through the Coates filter, in a bull market, the vast majority of traders on the vast majority of days are going to be experiencing these really nice surges of testosterone. Whereas short sellers are getting beaten up and experiencing the cortisol surges. And then one day, when something breaks, it completely flips.
Research into penny stocks suggests that some retail investors are in it for the lottery effect—they don’t care if the stock is a scam or viable, they’re just looking for a gambling high. Do you think retail investors are imparting much useful information into the stock market with their trades?
In a way, I respect that mentality because there’s a certain honesty to it. I think that a lot of, quote, investors in America have bought into this mythology about how the price of an equity is connected to the underlying economic health of the company. I do what I do in substantial part because I feel like I’ve been disabused of that notion.
In a way, that retail mindset is sophisticated because it’s attuned to that. It also works less when there are companies that have larger institutional components. We consider very carefully what we’re going to short, and one of the things we look at is the shareholder base. And if it’s a really heavily retail name, it either has to be a different kind of thesis or we stay away from it. Our assumption is that retail investors aren’t going to read it.
As a short seller, it’s tough to make the argument that something doesn’t have value when I don’t think the people owning it expect it to have value anyway. But as you move up to larger companies, more institutional shareholder bases, yeah, you still have the investors who are driven by fundamentals.
Even they realize more and more that fundamentals don’t actually matter all that much. As an activist short seller, we have to look at what investors are thinking is the reason they own this. If there’s a problem with that reason—if it’s been misrepresented, or if it’s a lie, then that’s what we can go after. In a simpler world it would really just be about the underlying fundamental value of the company, but we don’t live in that simple world. It’s often about something else.
Does the investor base of Tesla make it a harder stock to short?
[Laughs.] Going up to $1,500 shows that it’s a pretty tough one to short. Look, it’s not a growth company, people talk about it like it’s a growth company. It doesn’t actually make money on its cars; people talk about it being profitable. Tesla—I was going to say it’s a Rorschach test because people see what they want to see, but I don’t even think it’s that.
People want a hero. They think it’s Elon Musk. I think that what ultimately breaks Tesla—which, I don’t know that we’ll see this in our lifetime—is liquidity becoming tighter. Money becoming dearer breaks that and a lot of these other stocks.
As broken as I think equities are and have been for some period of time, I do still believe, and I think short sellers do largely believe this, that someday, the laws of economics, and the need for companies to have cashflow, will catch up to it, and that the market at some point in time will reflect that reality. But when will we see that? Who knows.
[Muddy Waters has been short Tesla stock in the past but doesn’t have a bet on the company now. Tesla didn’t respond to a request for comment.]
For short sellers, is it enough to find frauds? Or do you really have to focus on piercing the investor thesis, whatever that is?
There are two different approaches. If something is a fraud and the financials just aren’t what they company says they are, you don’t really have to care much about the bull case. I mean, that’s my view. You just go right after it and say, look, they’ve been lying about almost everything and here’s what the truth is.
When it comes to something that’s not a fraud from the legal standpoint, if you look at these companies that have monster valuations but their income statements are a disaster and nobody cares, because there’s something cool about them, you have to look at the investor case as the legs of a stool. And you have to kick those legs out from underneath it.