Four Reasons the Attack on Short Selling Is Unreasonable

I can’t quite figure out why the government and people in general are eager to enact new rules like the uptick rule and individual stock circuit breakers to combat short selling as if it’s an evil thing.

I do understand how aggressive short selling can disrupt a situation where leverage is used or other forced actions are required based on price action and valuation changes. I’d say these situations need to be dealt with fundamentally and not by trying to protect something which is obviously unstable by limiting the ability of the markets to correct it.

Here are the reasons that this line of attack seems unreasonable:

1. Short sellers are fairly small in relation to markets overall. While they can be felt in focused areas, funds available for short selling are small in relation to pools of assets that can make long investments. Short selling can make a real impact when it is focused and especially where markets are thin. But they are far too small to be labeled a major part of the problem. They may have been a catalyst to accelerate or cause some bad structures to tumble but they are not strong enough in and of themselves to be a primary factor.

2. There are a variety of reasons to sell short, most of them are neutral or positive, not evil. For example, we use short positions as a way to lessen our market and sector risk against our long portfolio. It stabilizes our overall equity value and allows us to further enhance our returns based on good stock selection. For example, one would want a long position in Apple (AAPL) based on their strong fundamentals but a year ago the stock was hovering between $160 and $180. So even though a long position in AAPL is “correct” from a research standpoint (at least ours), the valuation and market risk means that today you are down materially if you didn’t take some risk-limiting or buffering action. Most efficient asset allocations would include short selling or short positions as part of an overall strategy.

3. Options and derivatives are another way to have a short position. One can sell calls, buy puts or enter elaborate combinations of contracts to effectively establish a “synthetic short” anyway. If you’re large enough, brokers like Goldman Sachs (GS) or JP Morgan (JPM) can create a special contract for you that isn’t even traded in the public market. So focusing on just one method of being short (short-selling the stock) seems odd.

4. What about rules on the other side of the ledger? What about funds that buy stocks, especially thin ones, at the end of the quarter to enhance quarterly returns? What about investors and sometimes managements that target a stock with a large short position and intentionally try and “squeeze the shorts” to goose the price of a stock? There are just as many abuses by unscrupulous types on the long side as the short side. Spreading a false positive rumor can be just as effective (and illegal) as spreading a negative one and being positioned to make profits from the likely market reaction.

There do appear to be areas like fail to deliver and others that make sense to crack down on. Targeting a type of investment seems just plain wrong if a market is to function properly. Short sellers contributed to the drop in PALM to $1.20 just a few short months ago. We were only too pleased to buy stock there, thank you very much. That’s what makes a market.

Speculators and investors long or short are putting their capital at risk. Their rewards and punishments are meted out by the market. Bad decisions and management brings one to ruin, good decisions backed up by strong research, valuation analysis and risk management make you rich. Hasn’t all this already been covered already somewhere like “Markets & Investing 101?”

Not happy to be up on the soapbox so I’ll get off now.

Disclosure: Research 2.0 maintains a small, actively managed portfolio of technology stocks to put our ongoing research conclusions for validation. Risk management includes a dynamic adjustment of position sizes and the use of short positions and options.

Comments

[koolsool:]

Everyone knows that it is short-selling hedge funds, naked short-selling & no uptick rule that has destroyed trillions of dollars of value from working-class people's IRA & 401K. Not to mention pension funds & college endowments. People forget that the uptick rule was in place up until 2007, short sellers act like it is their right & that the uptick rule is some new thing that we have never had before. The wealth destroying greed needs to be regulated. All regular investors want is the rules to be enforced the way they were written before the Chris Cox SEC changed things. Powering down the share prices of America's investments does nothing but make the American middle-class poorer & a small group of greedy traders wealthy.

Apr 12 10:29 AM

[afoolandhis...:]

koolsool = moron

even if you repeat it a million times it won't make it true. short selling didn't cause the problem. bad management or bad business models caused the problem. short seling only exposes the the issues. idiots like you deserve the losses you exposed yourself to

Apr 12 12:45 PM

[Longinvestor:]

Kris Tuttle: "I can’t quite figure out why the government and people in general are eager to enact new rules like the uptick rule and individual stock circuit breakers to combat short selling as if it’s an evil thing."

As one of those people in general, I have eyes that see...and I see evil.

Apr 12 02:14 PM

[Portfolio M...:]

When the SEC temporarily banned the shorting of financial stocks, how did that work out for you, Longinvestor?

Apr 12 04:40 PM

[carey_jim:]

I agree with your feelings but not the title of your article.

In fact, it was very reasonable to try to limit or stop short selling, for certain stocks for a period of time, but it wasn't 'reasonable' in the sense you are talking about.

What I mean is that many (the best?) human beings are essentially gamblers and that is why we buy stocks in the first place. Reason is only part of what motivates us, and we the people (the government) shouldn't try to be too reasonable about these things or we will find ourselves living in a utopian fantasy and not reality.

People are going to gamble that a price will go up and they are going to gamble that the same price will go down. They'll gamble about the weather, their health and a baseball score by going both long and short.

I wouldn't call it unreasonable to ban this kind of gambling but too reasonable. Let human beings be what they are and don't try to force them into a straight jacket of reason.

As Ralph Waldo Emerson said,

"You can drive (human) nature out the front door with a pitch fork but she will come back in through the window."

Apr 13 12:51 AM

[THofler:]

Hoo Boy Portfolio Manager,
When the SEC banned short selling for a brief time I had massive gains (or recoveries) in most of my financial stocks & I took the opportunity to unload some of it.

The author's argument that short selling volume is thin, is nonsense. Prior to the recent great winnowing of the hedge fund space, hedge funds managed a large amount of money, but very much less than mutual funds & long ETFs. But hedge funds were levered somewhere between 2.5 & 4.5 to 1.

And, the velocity of trades at a hedge fund can be huge. At one point in the last few years, the NASDAQ fund within Renaissance Technologies traded 10% of all trades executed on the NASDAQ. While I have no idea what fraction of those trades were shorts, I'll bet it was a lot.

Does the author know that prior to the short ban, the SEC allowed most brokerages 60 days to settle a short sale? That was a catastrophy for the market since whole bear raids lasting weeks could be done on naked shorts without ever bothering to deliver any shares until the position was covered.

I think the SEC should require 1 hour settlement on all short sales, as this is the only way to guarantee a proper borrow.

The point about switching to the options market or other methods, is well taken.

Apr 13 01:44 AM

[Kris Tuttle:]

Thanks for the comments. FWIW the original title of the post on our own blog is "What's so special about short selling?" and we are in favor of regulation that prevents abuse, reduces or eliminates counter-party risk, and curtails strange and unusual practices.

These exist on both the long AND short sides of the investment world. Unreasonable leverage works both ways as do many other unsavory practices. So our point is more along the lines that focusing on short-selling alone seems short-sighted and narrow-minded.

Apr 16 04:10 AM