Don't Sell Short Selling Short

Email Print
FacebookTwitterShare


DIGG THIS

Stockholders
and managers of firms, whose interests lie in higher prices for
what they own or manage, miss few opportunities to deride short
sellers
. As Holman Jenkins of the Wall Street Journal
put it, "short selling is a business widely unpopular with
everyone who has a stake in seeing stock prices go up."

Regulators,
whose blunders short sellers frequently reveal by discovering
fraud that escaped their attention, respond similarly. That combination
of interests helps explain why, at various times, short selling
has been banned in many countries, including England, France and
Japan.

Such views
are reinforced by accusations that short sellers hope for bad
things to happen. Others misplace the blame for the association
between short selling and falling stock prices, especially in
a "crisis." False comparisons, such as holding short
sellers to a standard of perfect foresight, are also used to attack
them. However, all of these attacks are misguided.

Short selling
is part of the information-revealing process that Mises, Hayek,
and others emphasized as the central aspect and advantage of the
market process. In a world of uncertainty and change, information
is the scarcest good, and short selling is an important source
of additional information that would otherwise be lost.

Allowing
short selling increases the number of people with an incentive
to discover valuable information about firms’ prospects, by providing
an added mechanism to benefit from information that turns out
to be negative. When someone’s research or information leads them
to negative conclusions about a firm, short selling allows them
to communicate their less optimistic expectations to others and
make a profit if they anticipate the direction the market will
later come to agree with. That is, they profit only if they come
to "correct" conclusions before others. In the process,
they benefit others by revealing accurate information sooner than
would otherwise be the case, reducing the mistakes people would
have made from relying on the less accurate prices that would
otherwise exist.

Negative
information may not be as valuable as positive information for
purposes of cheerleading, but it is just as valuable when people
wish to make the best use of scarce resources. That is sometimes
reflected in the observation that much of economics involves negative
information — knowing some things not to do, rather than
knowing what to do — especially in combating the trouble
that arises from "knowing so much that ain’t so."

There is
no reason why information that might have negative implications
for firms would only be revealed to or discovered by those who
are already owners of a particular stock. To attack or restrict
short selling is then to restrict the market’s ability to elicit
and integrate all available information.

Restrictions
on short selling are analogous to a voting process where there
are only the possibilities of voting yes (owning shares) or abstaining
from voting (current non-owners), but "no" votes (selling
what you do not own) are impossible. People can vote yes, buying
shares and pushing up stock prices, or those who previously voted
yes can decide to go back to abstaining by selling their shares,
lowering stock prices. But short sellers allow current abstainers
to vote "no," giving themselves the ability to benefit
from their different views while benefiting others via market
prices, without having to first own shares in a company.

Short selling,
which allows profits to be made from negative information, is
akin to another aspect of a competitive financial market —
hostile corporate takeovers. Management groups who fail to make
the best use of their company’s assets object to the prospect
out of their own self-interest. But hostile takeovers provide
a mechanism for even those investors who own no current shares
in a firm to benefit from negative information. If a firm is poorly
run, even someone with no initial position in a company can purchase
shares at a price capitalizing its prospects under current management.
By then accumulating enough shares, and taking over management,
"takeover artists" can gain from eliminating inefficiencies
and improving results. This expands the number of potential investors
who have incentives to discover such negatives and "fix"
underperforming companies.

Short sellers
have been portrayed as heartless opportunists, benefiting from
bad outcomes. But they are no different from doctors who profit
from our illnesses, or teachers who benefit from our ignorance,
or locksmiths who benefit from criminal acts. Further, one’s belief
that future reality is more negative than others believe it to
be does not change that reality. It simply conforms market beliefs
more accurately to it, when short sellers are right — the
only situation in which they can profit from their forecasts.
Revealing mistakes is socially beneficial, and a far cry from
just hoping for bad outcomes (just as parenting sometimes involves
deflating children’s false hopes, not to harm them, but to help
them make better choices).

What is called
short selling in the stock market is common in all sorts of businesses.
A farmer who sells on a futures market when he plants, before
he has produced his output, does the same thing. So does a homebuilder
or custom tool maker producing to order. And that knowledge is
hardly new. As the 1909 New York State Commission on Speculation
noted, "Contracts and agreements to sell, and deliver in
the future, property which one does not possess at the time of
the contract, are common in all kinds of business." There
is no reason why a practice commonly accepted in business, which
participants must therefore view as beneficial, is somehow harmful
to those participating in the stock market.

Regulatory
opposition also indicates the positive consequences of allowing
short selling. Regulatory agencies are supposed to prevent fraud,
questionable accounting, and other management misbehavior. However,
they often fail not only to prevent, but even to detect them.
Short sellers who are betting their own money on being correct
often uncover what regulators miss, as they did at Worldcom, Enron,
Tyco, etc., showing themselves as more effective market policemen.

Regulators
then object precisely because their inadequacy is revealed. In
fact, their often-ineffective regulatory oversight makes markets
less efficient, by giving participants more confidence in stock
promoters’ assertions than is warranted. But they try to make
short sellers into scapegoats, allowing regulators to leverage
their failure into further expansion of their powers, to combat
short selling’s supposed evils.

Opposition
to short selling also confuses correlation with causation. Selling
short only lowers the price sooner than would otherwise occur.
It cannot force the price down for long if the fundamental circumstances
do not support it. Short sellers simply recognize negative information
sooner. Their activity can begin the process of reducing market
prices, but it is the negative information that causes stock prices
to fall. And even when short sellers are wrong, they provide extra
profit opportunities to those who expand their holdings at the
temporarily low prices that result, a benefit ignored by those
blinded by their exclusive devotion to "what’s in it for
me?"

Opposition
to short selling is often no more than objecting to its effects
on a particular stock the opponent currently owns. The only principle
involved is that of preventing any change that might lower the
price of what one owns (which is then over-generalized, as the
Luddites‘ opposition
to losing their threatened jobs to printing presses was dressed
up as principled opposition to technology in general), ignoring
the benefits to society from revealing more accurate information.

Short sellers
are also attacked for allegedly spreading negative rumors that
sometimes turn out to be false. But false positive rumors are
regularly asserted by a far larger group who benefit by pumping
up stock prices, from managers to brokers to financial talk show
touts. But critics of short selling are only concerned about what
they don’t benefit from. In addition, the consequences of all
forms of potential misinformation are made more problematic by
the belief that regulatory agencies actually protect investors
from it, when they really don’t. Without that unwarranted confidence,
investors who knew to be wary, or to trust only those who had
earned superior reputations that they would put at risk, would
be more accurately informed than they are now.

Short sellers
are also criticized whenever they are wrong. But holding them
to a standard of correct expectations is an impossible standard.
No one has perfect foresight. People who buy stock are not always
correct that it will go up thereafter. And even if they were,
those who sold the stock to them would have to have been wrong
in their judgment. Applying such a standard of perfection to short
sellers alone is just a mechanism to attack them, not a serious
idea.

Firms do
not always stop their aversion to short sellers at negative attitudes.
They often directly attack them. For instance, The Economist reported,
"Not long before Tyco went bankrupt it was still buying full-page
advertisements to campaign against short-selling." Similarly,
within a month of Biovail filing suit against short sellers for
expressing negative opinions about it, the SEC announced an investigation
which led to a settlement involving serious fraud charges.

Perhaps
most telling about the assaults on short selling is a 2004 NBER
study that discussed the fact that "Firms use a variety of
methods to impede short selling, including legal threats, investigations,
lawsuits, and various technical actions." It revealed the
high probability that firms attacking short sellers actually have
something to hide, indicated by the fact that "firms taking
anti-shorting actions have in the subsequent year very low abnormal
returns of about –2 percent per month."

Short sellers
receive widespread condemnation. But it is undeserved. They are
no more self-interested than others in financial markets. They
improve the information incorporated in market prices that we
all rely on to improve social coordination, as we seek to make
the best of a world of unavoidable scarcity. The attacks against
them are poorly thought out, and often come from those whose real
abuses or regulatory failings short sellers threaten to uncover.
It is time we stop selling short the short sellers.

April
7, 2007

Gary M.
Galles [send him mail]
is a professor of economics at Pepperdine University.

Email Print
FacebookTwitterShare