Another Defense of Short Selling

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"Without short sellers, ‘there would be no one to criticize and restrain the false optimism that always leads to disaster.'" ~ Bernard Baruch

Amid the difficult markets of recent vintage the role of the short seller has once again come into question. According to some, short sellers hastened the demise of firms such as Bear Stearns and Lehman Brothers. When the collateral damage of both firms' decline was taken into account, seemingly easy solutions were naturally trotted out by regulators.

In particular, a ban was briefly put in place in the fall of 2008 on the short selling of over 900 financial stocks. With banks widely seen as an essential input to the health of the U.S. economy, trading that would imperil their ability to operate was viewed in a negative light.

At a cursory glance, some might see the value of such a rule. Short sellers profit only on the decline of a firm's prospects, so to remove this negative influence might on its face appear as a positive.

But short selling is just one form of trading that enables stocks to converge toward their true value. The harm brought by rules that make price discovery more difficult can't be overstated. Short selling may be rare, but it is extremely helpful for bringing rationality to pricing. It reduces the waste of capital and signals to company managers that they are faltering. Perhaps its least discussed benefit is to provide a floor during major market plunges.

Short selling is risky and rare. It would be hard to find a more risky form of investment than a short sale. While those who simply purchase shares only risk losing their investment, that can't be said for short sellers.

First off, short sellers borrow shares that must be returned to the individual from whom they were borrowed. In the meantime, the short seller sells the shares into the marketplace on the assumption that they can be purchased at a later date for a lower price. It's a nice trade if the shares sold short decline in value, but there is an obvious risk that the shares will move powerfully upward. If so, the potential losses that short sellers face are unlimited.

There are many examples to point to. Back in 1996 shares of Internet pioneer America Online were testing single digit lows. Not long after, AOL shares skyrocketed in value on the way to six different stock splits. The unlucky individuals who were short AOL shares were surely burned to a degree beyond the experience of long buyers.

This of course explains why short selling is so rare. According to the firm Data Explorers, a global securities lending service provider, as of December of 2008, only 1.99 percent of the shares of the S&P 500 had been sold short.  As for hedge funds that are supposedly in the business of short selling, they only account for a small part of the hedge fund industry, holding roughly $181 billion in assets compared with industry assets that reached $1.41 trillion in December of 2008.

Despite its miniscule share of the market, this form of trading still has a negative image owing to the belief that a group of "speculative" short sellers can effectively obliterate a company whose shares are in trouble. No doubt that's possible if a company's fundamentals are poor. But to motivate an individual to sell a certain firm's shares short, there must be a speculative buyer on the other end of the trade who thinks the short seller is incorrect. Speculation is always and everywhere a two-way street.

Naked short sales. Some who see no problem with the act of short selling do look askance at the process whereby bearish individuals engage in "naked" short sales. Naked short sales are illegal, but they don't merit the scrutiny or negative image that many in the press give them.

Actually, nearly all short sales at the time of transaction are "naked." That's because with the liquidity or borrow on most shares very plentiful, a broker can transact a short sale with full knowledge that there exists a "locate" on the shares in question. To use but one example, the shares of ExxonMobil are highly liquid. So while a dealer who sells XOM shares without locating them first would do so with good knowledge that the shares could be found.

This explains why, even if naked shorting were legal, it would not present the difficulties that so many suggest. Simply put, naked short sales that lead to a "failure to deliver" of the shares sold short are rare precisely because it is not the short seller who is locating the shares in question. It is the prime broker who, eager to maintain a reputation for not breaking trades, has an incentive to make sure that shares being sold short for clients are locatable so that the transaction can be completed.

Opponents of naked shorting allude to all manner of broken trades and "counterfeit" shares, but according to the SEC, "99 percent of all trades in dollar value settle on time without incident." And of those trades that do not, a report by the Coalition of Private Investment Companies notes that "85 percent are resolved within 10 business day and 90 percent within 20 business days."

Detractors also point to short interest in companies that exceeds the number of shares outstanding, but that's an empty protest. The reality is that there are no laws against the multiple borrowing of shares outstanding. In that sense, the buyer of shares from a short seller is not prohibited from turning around to lend those shares to another short seller. All of this is entirely legal, and explains instances where short interest is greater than the total number of shares issued.

It should also be remembered that long buyers of shares are not infrequently "naked" at the time of purchase. While the buyer's account is credited with the purchased shares right away, the transaction doesn't close right away in order to give the buyer time to furnish the cash to complete the purchase. Similarly, it could be said that margin purchasers of shares are naked too, but there's no law against that either.

Naked buying and short selling both serve investors well by increasing the pressure on share prices to reflect the consensus of the marketplace.

Short sellers bring the economy undeniable good. Although most portfolio managers have a limited selection of companies that they're invested in, nearly all have what is called a "watch list" of companies that they would like to own. In most instances they may like a company's fundamentals and business model, but if the shares are selling at a multiple which makes them too expensive, they lie in wait before actually purchasing them.

In that sense alone, short sellers add to the investment marketplace. To the extent that short sellers bring rationality to the share prices of certain firms, the act of doing so can ultimately drive company shares into the hands of managers who are long-term oriented but willing to buy them only at what they deem the proper price.

Short selling is often part of a fund manager's long-term investment strategy. Specifically, some fund managers might be eager to purchase a stake in a certain company long, but fearful of making a money-losing purchase, will only do so if they're able to sell short the shares of firms with similar commercial outlooks as a way of protecting their downside.

Thinking back to the fall of 2008 when short sales were briefly banned, what will forever remain unknown amid the scary share declines of financial firms is how different the outlook might have been had the short sale ban not been in place. It's all conjecture, but it's fair to say that some managers would have been willing to put a floor under the share-price decline of certain companies had they been able to short others. Lehman Brothers' collapse is regularly pointed to as the cause of all the market carnage a little over a year ago, but it could be credibly stated that the shorting ban played an equal if not greater role.

Short sellers do company managment a great service too. Negative earnings surprises are frequently preceded by abnormal short selling. When successful, short sales signal to management that something's amiss with regard to their operations. Short sellers provide market signals suggesting that management must improve what they're doing.

Most important, however, is the impact of short sellers on capital flows. To decry short sellers is to denounce the efficient deployment of what is limited capital. If they weren't allowed to shed negative light on company operations, share prices would be less reliable and capital inefficiently distributed. Short sellers speed up the essential process whereby capital and resources that are being wasted are redirected to managers who will treat both better.

Short sellers are buyers. Probably the least noted market benefit that short sellers bring is their essential role as buyers of shares. The seen in this case involves the money short sellers make when their speculations on shares prove correct. The unseen is what short sellers must do in order to record profits.

Those who sell shares short must borrow shares that eventually have to be returned to the individual borrowed from. In that case, short sellers truly only profit once they've re-entered the market, purchased shares, and returned them to the initial lender. Simplified, short sellers gain when the shares they sell decline, but they profit when they return to the market as buyers.

Considering painful market declines, short sellers provide the cushion or floor during times of distress. To see why, we must first go back to the Great Depression. On Sept. 21, 1931, in a compromise decision entered into to avoid the closing of the New York Stock Exchange, short-selling was forbidden. The rule was rescinded two days later, but abolition of short-selling was renewed in October, November and, once again, in January of 1932.  As Benjamin Anderson wrote in Economics and the Public Welfare, the short-selling ban led to share declines that "were more extreme," plus the subsequent "rallies were far feebler than would otherwise have been the case."

Returning once again to last year, what will forever remain unknown is the volume of buyers lost during collapsing markets due to brief ban on short sellers. Seeking to take profits, some might have returned to the market at a critical point, not to mention that some may have exited altogether out of fear of new rules that would distort proper market pricing on the way to them losing money.

If there's a silver lining to the modern ban on shorts, it would have to be that a dollar is the same in Tokyo and London as it is in the United States. Assuming future attempts to blot out this necessary form investment, it's a fair bet that other markets not regulated by U.S. authorities will eagerly take on the short selling volume that U.S. lawmakers seek to drive away.

Benjamin Anderson once observed that "Short selling is one of the most wholesome factors in the broad and active stock market. The bear, selling stocks short when they go too high, tends to hold them down, and that same bear, in order to take his profits, must buy stocks when they break."

Not only do short sellers put a floor under painful market declines, they avert them altogether for providing advance warning of poor business practices that must be corrected. To ban the activities of short sellers is to ignore reality, while promoting the improper allocation of capital.

Conclusion. Rather than introduce more rules that likely won't work in a globalized marketplace to begin with, policymakers should leave short sellers free to pursue their unique expertise in much the same way as buyers. Indeed, short sellers are buyers too, but only after investors have returned share prices to what they deem the proper levels.

John Tamny is editor of RealClearMarkets, Political Economy editor at Forbes, a Senior Fellow in Economics at Reason Foundation, and a senior economic adviser to Toreador Research and Trading (www.trtadvisors.com). He's the author of Who Needs the Fed?: What Taylor Swift, Uber and Robots Tell Us About Money, Credit, and Why We Should Abolish America's Central Bank (Encounter Books, 2016), along with Popular Economics: What the Rolling Stones, Downton Abbey, and LeBron James Can Teach You About Economics (Regnery, 2015). 

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