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Don't Sell Short Selling Short (In Defense of Short Selling)
Mises.org ^ | 4/6/2007 | Gary Galles

Posted on 10/09/2008 5:58:29 PM PDT by arista

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.


TOPICS: Business/Economy
KEYWORDS: business; fec; regulation; shortselling; stockmarket; wallstreet
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1 posted on 10/09/2008 5:58:29 PM PDT by arista
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To: arista

I do not have a problem with them selling short...Just post their real name.... Let’s see who has the balls to stand behind their position!!!


2 posted on 10/09/2008 6:01:43 PM PDT by pointsal
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To: arista

I want the right price, not the bubble price. We’d have a lot more bubbles without short sales.


3 posted on 10/09/2008 6:01:49 PM PDT by ari-freedom (Betcha they're good. Why shouldn't they be? Their one mistake was giving up me!)
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To: arista

Okay, I won’t sell my shorts.

But should I launder them before I sell them?


4 posted on 10/09/2008 6:03:21 PM PDT by Old Sarge (Illic Est Haud Deus)
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To: arista

I disagree. No clandestine group should be allowed to use investors’ accounts to scare herds of other investors and sink competitors’ businesses. IMO, the uptick rule and watchers are needed.


5 posted on 10/09/2008 6:04:01 PM PDT by familyop (cbt. engr. (cbt), NG, '89-'96, Noachide computer geek)
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To: pointsal

Dollars are anonymous, and the market price is the only information you need. I don’t see what difference publishing names would make.


6 posted on 10/09/2008 6:04:27 PM PDT by fhayek
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To: fhayek

I think publishing names would be a violation of people’s financial privacy. It would be just as bad as publishing every credit card transaction.


7 posted on 10/09/2008 6:07:03 PM PDT by arista
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To: familyop

I understand the concern, but restricting short-selling is very much a way of saying you support “the free market,” except when you don’t like its outcomes...


8 posted on 10/09/2008 6:14:01 PM PDT by seacapn
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To: pointsal

dartuser is short the Russell 2000.


9 posted on 10/09/2008 6:19:06 PM PDT by dartuser ("If you torture the data long enough, it will confess, even to crimes it did not commit")
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To: familyop

the watchers are those who go long on those same stocks


10 posted on 10/09/2008 6:21:31 PM PDT by ari-freedom (Betcha they're good. Why shouldn't they be? Their one mistake was giving up me!)
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To: seacapn

sounds just like how freddie mac works. privatized profits and socialized risks


11 posted on 10/09/2008 6:22:59 PM PDT by ari-freedom (Betcha they're good. Why shouldn't they be? Their one mistake was giving up me!)
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To: arista

Short selling is nothing but selling the same shares twice. Yes they do buy them back, but only after they artificially inflate the float, which drives the stock down. Its a myth that they help the market. Did anyone ever meet a short seller that wanted the market or stock that they sell short to go up? I didn’t think so.


12 posted on 10/09/2008 6:26:37 PM PDT by Racer1
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To: Racer1

Name me one market where all parties wanted the price to go up. Every seller is hoping that he is selling at a peak, every buyer is betting that he is buying at a valley. This is how markets work.


13 posted on 10/09/2008 6:32:21 PM PDT by fhayek
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To: familyop; seacapn
Further to seacapn — the uptick rule accomplished a lot less than you'd imagine. There's always an uptick.
14 posted on 10/09/2008 6:34:03 PM PDT by USFRIENDINVICTORIA
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To: Racer1

Shorts do not sell the same shares twice, they borrow them from someone who actually owns them to sell. They do not affect the float in any way since the shares have to be there to borrow.
Short provide liquidity to the market and trust me when the stock/market is tanking shorts can provide ‘brakes’ when they all start buying to cover.
Yes I am a proud shorter. I prefer it to long any day.


15 posted on 10/09/2008 6:41:11 PM PDT by sheana
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To: sheana

“Shorts do not sell the same shares twice, they borrow them from someone who actually owns them to sell.”

Well that’s all well and good - but the problem is NAKED short selling.

If you can keep selling, and dry up all the buy orders WITHOUT REGARD TO WHETHER OR NOT YOUR BROKER HAS THE SHARES TO LEND, OR IF INDEED THEY REALLY EXIST, you see the market drop 700 points today.

When FTC, or Failure To Cover, goes unrecognized and unpunished - shorts run wild.


16 posted on 10/09/2008 6:49:21 PM PDT by StatenIsland (The '08 Election: It's about the survival of our country, not making a point...)
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To: seacapn
"I understand the concern, but restricting short-selling is very much a way of saying you support “the free market,” except when you don’t like its outcomes..."

It can be used for conspiracies to vandalize stocks and essentially steal from other investors. It's about as moral and free-market-worthy as using false environmentalist front-witches in commissioners' meetings to stop competitors' projects from starting, IMO.

But that won't matter much for the near future. Investment banking is going to China now. We'll see how the PLA deals with disruptions. Me...? I'll put my tiny little bits in deposit banks and do the building myself.


17 posted on 10/09/2008 6:49:31 PM PDT by familyop (cbt. engr. (cbt), NG, '89-'96, Duncan Hunter or no-vote)
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To: StatenIsland

If you can keep selling, and dry up all the buy orders WITHOUT REGARD TO WHETHER OR NOT YOUR BROKER HAS THE SHARES TO LEND, OR IF INDEED THEY REALLY EXIST, you see the market drop 700 points today.

I traded stocks for 5 yrs, mostly shorting. I couldn’t tell you how many times I pushed that button and was told....no shares available. If the broker doesn’t have the shares to lend you don’t get them! sheesh


18 posted on 10/09/2008 6:53:30 PM PDT by sheana
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To: ari-freedom
"the watchers are those who go long on those same stocks"

That's true. Anyway, we're looking at some big changes ahead. We'll be a Nation of savers and builders, or else...

It will be very interesting to watch investment banking in China during the coming years. One difference there is the savings culture. We'll see if that holds up after the present building of infrastructure, when heavy consumerism will be happening there.


19 posted on 10/09/2008 6:56:18 PM PDT by familyop (cbt. engr. (cbt), NG, '89-'96, Duncan Hunter or no-vote)
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To: seacapn

We might be talking about two different kinds and purposes of short-selling, BTW. I’m referring to pre-planned and coordinated group efforts that are executed only for the purpose of driving competitors’ stocks or natural resource commodities down.


20 posted on 10/09/2008 7:01:40 PM PDT by familyop (cbt. engr. (cbt), NG, '89-'96, Duncan Hunter or no-vote)
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