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Is Shorting Evil?

Is Shorting Bad? Is Short Selling Evil?

Q:Personally I do not like shorting. The idea that you can sell something you don’t own is somehow unethical and morally disturbing…

Frankly, I’d be happy if it were banned. It creates an artificial market by increasing the number of shares traded beyond the number of shares issued…

A: Yeah, how can you sell something you don’t own? Sounds like it has a bad ring to it huh… Well, it’s done everyday in real life. For instance let’s take the case of when you, say subscribed to an investment newsletter. The publishing company did not have next month’s issue printed when they took your order. So they actually sold next month’s issue of the newsletter short. Now the publisher has the obligation of putting a newsletter together and delivering it to you as promised. You expect that they will because they have done it over and over in the past, but you have still taken a risk. The publishing company also took a risk in accepting your order. They have to sell the newsletter to you at a profit or they will eventually go out of business. So basically you took a risk in buying something the provider didn’t yet have and the provider took a risk in delivering it at a profit. Most enterprises are run this way. They have to get the newsletter to you at a profit. Otherwise they eventually will go broke. In summary, you took a risk in buying something the provider didn’t have. The provider took a risk in delivering it at a profit. Most businesses are run this way.

‘Short selling is more risky than going long (potentially unlimited losses if the underlying asset continues to rise) and only possible if and when a security has been over-hyped. So if anything, short sellers should be lauded for knocking the froth off toppy shares before other investors pile in and get burned. And don’t forget: just like a CFD trader, stock buyers making money from rising stock prices are not raising so much as a penny for the underlying company – they are merely trading second-hand shares bought from other investors’ – MoneyWeek

There’s nothing evil about short-selling, rather I would say that short-sellers make the market more efficient as they challenge market’s consensus view regarding a stock’s business model or valuation. If a company has a flawed business model or is overvalued the laws of supply and demand are likely to prevail at some point and the shares will fall in the end, irrelevant of the presence of short-sellers as shareholders flee the ‘sinking ship’. However short-selling by its very nature is a tough way to make a living, we know that equity markets tend to rise over time as market participants are by nature generally optimistic so the odds are stacked against short sellers from the outset. It’s tough emotionally. If you short a stock at $20, the most you can make is $20, but there’s no limit to how much you can lose. People on the short side will do and say things to try to get their positions to fall; people on the long side do, too. Personally, the more a share is ramped up on the various bulletin boards then the more I steer clear of it. Some of the things they do may be inappropriate. Being short stocks is a tough psychological game.

Shorting is a sensible money making strategy in a bear market. Without derivatives that allow people to go short, I can guarantee you the stockmarket would be far more volatile than anything you’ve ever experienced. In general there is nothing morally wrong with people profiting from shares falling, just the same way as there is nothing wrong with people profiting from shares rising.

In a raging bull market prices can depart from their intrinsic value caused by the imbalance of sellers and buyers. In a market collapse long only investors will likely panic sell. At such a time a short seller is more likely to buy stock to close out the short position. This mechanism provides a floor for long only investors. If bad news is not reflected in the share price, then long only managers and their investors risk a market that is akin to a ponzi scheme. Thus the efficiency benefits of allowing short selling decreases the risk of over-inflating stock values and thus better protects superannuation funds.

“Bears can only make money if bulls push up stocks to where they are overpriced and unsound… Bulls always have been more popular that bears… because optimism is so strong.. Still, over-optimism is capable of doing more damage than pessimism since caution tends to be thrown aside… to enjoy the advantages of a free market, one must have both buyers and sellers, both bulls and bears. A market without bears would be like a nation without free press. There would be no one to criticize and restrain the false optimism that always leads to disaster. (Staley 1997).”

Most seem to forget that every short sale results in a corresponding buy or purchase – just at a later date. If you get the short wrong – which, by the way, occurs more often than not – you are forced to buy back at a higher price and incur a loss. If the so called shorters push the price of the share below what constitutes fair value, they will get their fingers burnt. Traders will move and bid the share price back up again. I am not saying the market is perfect and there are short term swings that pull prices out of line…

People seem to have an emotional reaction to shorting, and take it very personally. But why should selling be any worse than buying? If a company (or sector) comes ‘into favour’ presumably you would not object to making money on the consequent price rise. So why should you object if people make money on the price falling when it is out of favour? I don’t think you can really blame short sellers for all the vagaries and irrationality (or abuse) of the market. Being a “good” company won’t save you if the market doesn’t believe you. For instance look at Royal Bank of Scotland; RBS may (or may not) be a fantastic company, but that hasn’t stopped the price falling drastically. It’s not a conspiracy against small investors, it’s just that a lot of people think RBS and the banks generally have a lot of big problems – largely of their own making.

Some people like to blame CFDs for increasing volatility in the market. While it may be true in cases where hedge funds have shown a particular interest in one select stock, it is generally not the case. More shares have become available because big pension funds managers are making their stock positions available to the market in what we call ‘stock lending’. If someone is going short a stock, say AstraZeneca, in reality they are borrowing that stock from somewhere and selling it to the real market. They are selling something physical – they just promise to buy it back at some point when the fund manager wants the stock back. The more shares available on the market, the more it will tend to create a much more prompt equilibrium between buyers and sellers. I should point out that even in countries where shorting is illegal it did not prevent the market from collapsing. The Hong Kong market is a classical example of that.

To repeat, short selling is not just selling – it is selling then buying, on the view that in the intervening time something will occur (e.g. bad corporate news) to drive the price down. It is no different from buying, then selling, with the view that in the intervening time good corporate news will drive the price up. All stock lending facilitates is the ability to trade in both directions. Anybody who thinks that markets have some sort of moral duty to only move in one direction, i.e. upwards, is (a) ignorant of history, and (b) forgetful about the 2 emotions that drive prices – Greed (which tends to make them go up), and FEAR (which tends to make them go down). Right now markets are most definitely gripped by the latter. Hedge funds and other short sellers didn’t cause this (people borrowing too much in the US did – from irrational greed), but it’s wrong to get angry at those who try and profit from the way financial markets are currently behaving.

So called ‘aggressive’ short selling, whereby hedge funds sell stock in an effort to force it down towards some real or imagined trigger point, is only a small part of the overall short selling market. Other parts are for index hedging, option and futures trading, long/short managers, and so on. If all stock lending was stopped, then financial markets would dry up considerably, and that wouldn’t be good for anyone.

I would say that shorting isn’t the problem; the problem is shorting accompanied by orchestrated negative publicity campaigns that include wild speculation and/or blatant untruths, especially when relayed by “tame journos”. That is market abuse. And you don’t need to go far to see it – the dreadful and illegal attack on HBOS was a complete expose on how these crooks work. I don’t see a problem with shorting myself, as long as it is done in a regulated environment. I do think the regulatory bodies need to tighten up on these things though and regulators are taking this direction by for example imposing disclosure rules to block the problem of non-disclosure of large covert stakes or short concealed positions in a company. Markets need full disclosure – and I’m of the opinion that open, declared, short selling may help the market. It would also be less likely to lead to sinister behaviour and cynical “raids”, but the emphasis here is on the openly declared form of short trading. Anyone holding more than 3% of a listed company’s shares is obliged to publicly declare their position, and is required to publicly announce every further 1% threshold they cross. I see no reason why similar thresholds shouldn’t apply regarding loaned stock.

At present, a major fund or bank or other institution can be identified as a substantial stakeholder in a company – and might be highly thought of by other shareholders for doing so – while at the same time sneakily loaning part of their holding in exchange for collecting a loan fee. The players to whom they loan the stock bear the brunt of the criticism, while the institutions themselves, assisting the villainous shorters, are allowed anonymity 😮 I reckon that whenever an RNS is issued detailing a shareholder’s stake – the announcement should show what percentage of that holding is or has been loaned out. Managers of pooled holdings (nominee accounts) should likewise declare loaned stock.

Also, regarding stock lending – lenders can and sometimes do withdraw their stock from lending when it suits them. This forces the shorts to buy back in the market and cover their positions – another reason why short selling is very difficult most of the time.

It’s not hard or expensive for the private investor to short stocks – any spread-betting firm provides that service. And the short selling service they and CFD providers offer is, of course, based on (and underpinned by) stock borrowing and shorting in the real market.

I would say that most complaints about short selling are a classic case of ‘privatise the profits and socialise the losses’. By this I mean that when things go well everyone likes to pat themselves on the back and say how clever they are. In contrast, when things go badly, rather than accept responsibility for poor decision making, everyone looks around for external culprits to take the blame. And right now these culprits are unnamed hedge funds/short sellers…

Short Selling

Q:Is short selling evil?

A: Generally, short selling is seen as a necessary, indeed desirable, feature of the market. If you want to argue that prices should reflect all information, both good and bad, then you have to have short-selling. Indeed, when the USA banned shorting in late 2008 the markets started a steep decline. Some people may argue that is it somehow dishonest to want to profit from a company’s share price decline but short selling is needed for full and accurate price discovery since the market always needs people on both the long end (owners/buyers) and the short end (renters/sellers) for it to work properly. Certainly short selling does no favours to the shareholders of the targeted company and it would be pointless to argue that there is no loss of value from short selling – if someone wins, someone must lose, but there are also advantages.

In fact, short-sellers are vital to limiting the sort of financial chicanery that led to Enron’s collapse, one of the biggest bankruptcies (well maybe not the biggest checking the long list of recent failures) in United States history. Investors have learned that you can’t really rely on auditors, you can’t really rely on the government and you can’t even rely on the financial journalists to expose the bad companies. Analysts, for example, are notoriously bullish regardless of the economic climate. Most of their recommendations are ‘buys’; only about 10% are ‘sells’. Only two months before it declared bankruptcy – ten of the 17 Wall Street analysts covering Enron still rated the company a strong buy.

Short-sellers, however, are adept at digging through balance sheets and other sources of information to sniff out corporate shenanigans. They can then drive down share prices to levels that more accurately reflect a company’s true fiscal health and the failed energy company was felled, in part, by James Chanos, a legendary short-trader.

The problem with the housing market was that a short selling market did not exist so people were unable to short sell houses which spiralled prices way above fair value – at some point the buyers balked and stopped buying which burst the bubble – the consequences have already been great and will have a long lasting impact to the economy.

To put this further into perspective we have to look at the tulip bulb market in Holland. Here, again there were no short sellers and the value of tulips became as valuable as real property. That until the market instantly revalued the tulip at the price of other vegetables and huge amounts of wealth were lost.

Advocates of short selling say that it provides liquidity and accelerating price corrections in over-valued stocks. By providing liquidity, short selling provides balance. Whether an individual is closing a long position by selling their shares or opening a short position by selling borrowed shares, they claim (perhaps correctly) that it’s one and the same thing – they both believe the stock is overvalued and will drop in price, so they decide to sell shares to someone who thinks the opposite. As such, some believe that short sellers can act to stabilise prices in a declining market.

Many take the view that shorting is an unethical practice; just last year Alex Salmond, the first minister of Scotland attacked the ‘short-selling spivs and speculators’ and blamed them for targeting banking giant Halifax Bank of Scotland, while the Archbishop of York, the Right Rev John Sentamu, likened short sellers to ‘bank robbers and asset strippers’. Critics say that mass shorting creates a disorderly market based on innuendo, fear and greed (how can a FTSE 100 company’s shares halve and double in the same day in a market that is anything other than disorderly?). Skeptics of the practice point out short selling can also increase share price volatility – and exaggerate price movements. In the cases of HBOS and Lehman Brothers, it is claimed shorting depressed the bank’s share price so much it undermined commercial confidence.

The other problem is that shorting as an activity isn’t regulated in the same way as shares. In this perspective it is simple to see why the Alliance for Investment Transparency (AIT) exists in the United States. This association of publicly traded companies advocates transparency in the market place. Now consider that hedge funds are Wall Streets biggest customers controlling over $1.5 trillion in assets. The Alliance for Investment Transparency is firmly of the view that despite attempts by the securities and exchange commission to regulate these funds, that the market remains vulnerable to illegal market manipulation schemes. The AIT has offered the view to the Senate that such schemes involve collusion between hedge funds and so called ‘independent stock analysts’ providing research on a stock. They are of the belief that stock analysts create that data and send it out into the market which in turn drives it down or up, depending on what the need of the investor is. This is what I often refer to in this site as noise.

I am not a fan of short selling. The principle of profiting from falling share prices sits disturbingly with that of investing your money in a company with the intention of seeing the value of that company grow. But the advantages and disadvantages of shorting stretch well beyond the satired image of greedy hedge funds profiting from the misery of others, as attractive as that caricature is to Labour MPs and tabloids.

CFD market has made shorting more popular as the CFD provides a convenient vehicle for ‘shorting’, it’s up to the dealer to decide whether to actually take a short position in the shares. The problem with banning things like short selling, is that you’ll push investors and speculators away from the main market, into other markets. Not only that but a modest amount of short selling helps improve the overall liquidity of a market – and so benefits everyone, by narrowing spreads. For instance if you are invested in a share and want to get out of it and there no shorters closing you might have to get out at a lower price and likewise if you want to buy into a share and there no shorters you would have to buy at a higher price. Hence, shorters improve liquidity. So, where do you draw the line as to what constitutes an abusive trade?

The truth is that there is no meaningful evidence that short selling depresses markets. The market is about value. Prices fall because no one is prepared to pay higher prices for these particular stocks. More importantly the market has not been proved wrong on a single occasion yet. Originally the US government blamed short selling for the sharp price falls in Fannie, Freddie and Lehman Brothers but on each occasion the fall was justified as the businesses all went belly up. The same thing happened with HBOS over here – again the short sellers were blamed but ultimately, given the governments lightening fast intervention, it is clear that all was not well with HBOS – again the market was proved correct.

The truth is that the prices on better run companies remain higher because the people who matter recognise value. If prices fall too low insiders buy and also tell their family and friends to buy to. Fundamental analysts also spot value. What the governments and the papers fail to really grasp here is that markets will fall (sometimes very sharply) when economic times worsen. This is because people are prepared to pay less and less for stocks.

Q:The big difference is that excessive shorting ‘can’ lead to the collapse of a bank which affects its customers, their businesses, and the wider economy… Whereas excessive ‘longing’ can only lead to losses of investors who didn’t do proper research.

A: No, that is not the only problem of excessive leveraged ‘longing’. The real danger is the gross misallocation of capital to unprofitable enterprises.

Capital misallocation is the root cause of this crisis. Not shorting. In an ordinary markets shorting just means you have to wait a while before getting back to normal prices because most shorters have a limited time-horizon and negative news-flow (a prime ally of shorters) doesn’t last all that long. The real problem with the crisis is that there was plenty of cash but it was in the wrong place!

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