Curb Short Selling? The SEC Resides in Unreal World

by: Value Expectations

By John Tamny, Toreador Research and Trading (Guest Contributor)

In a 3-2 vote two weeks ago, the Securities and Exchange Commission voted in favor of curbs on the short-selling of shares. In other words, the SEC chose to block out economic and financial reality.

On its face, this is quite something for a bureaucracy that lauded the merits of Sarbanes-Oxley in 2002. Back then it was said that balance-sheet transparency made Sarbanes-Oxley necessary so public companies couldn't obscure the truth about their assets and liabilities.

But now, in a Washington that has elevated the concept of self-unawareness to an art form, the SEC has ruled in favor of a regulation that ensures opaqueness when it comes to the true value of stock prices. Investors should be scared.

The ruling was defended by the SEC and some of its enablers as the rational response to the 2008 financial crisis. The basic argument offered was that unregulated short-selling caused the crisis thanks to short-selling "bandits" allegedly forcing down the share prices of companies, regardless of their underlying financial health. The argument is contradictory.

Indeed, lost in a Washington culture that promotes "doing something" at the expense of reason, short-sellers are an investor's best friend. To see why, the concept of short-selling needs to be defined.

In simple terms, the bearish looking to "short" a certain company's shares borrow those shares from an existing owner. They then sell the shares, bank the proceeds and hope that their less than sanguine outlook on the company is rewarded through a subsequent decline in the share price of the company in question.

That's their hope because sooner or later, they must return the shares to the original owner. In order for short-sellers to profit from the decline of a company's shares, they must eventually return to the market, buy the shares previously sold short and then return the shares purchased to the individual from whom they borrowed. Any profits result from the difference in price in the time between when they sold and when they re-entered the market.

The long-term investor with a stock position in the shares in question wins either way. Assuming the possibility that the short-seller's bearishness is unwarranted--which is a lot of the time--the seller, seeking to avoid losses on shares sold short, must re-enter the market in order to buy back the shares at a loss so that they can be returned. In this case, when short-sellers lose investors gain because their "covering" of their short sales leads to increased demand for the shares in question.

On the other hand, long-term holders of the shares also benefit when the bearish short-seller's negativity is warranted. They do because short-sellers are by definition buyers.

Assuming short-sellers are correct about a company's outlook, they must at some point buy back the share borrowed. In this sense, short-sellers put a floor under markets that are cascading downward. Their existence often protects those less eager to engage in short-term speculations owing to the likelihood that they'll eventually be buyers.

Is it, then, any wonder that markets were so spooked back in 2008 when short-sale curbs were initially introduced? For one, what right-thinking investor would want to own a stock the price of which does not include all information, good or bad?

For two, if we ignore how very informative short interest is when it comes to share prices, investors ultimately want downside protection. One way to ensure this form of protection is to allow short-sellers to do their work. Once again, short-sellers are ultimately buyers, meaning they are downside protection personified.

SEC Chairman Mary Schapiro acknowledges the importance of short-sellers to a certain degree but defended her vote for curbs with the suggestion that "excessive downward price pressure on individual securities, accompanied by the fear of unconstrained short-selling, can destabilize our markets and undermine investor confidence in our markets." With this in mind, restraints will be limited to firms whose shares have declined at least 10% in a single day. Schapiro's logic is backward.

Indeed, it is when investors are blindsided by the very corporate malfeasance and mismanagement that short-sellers seek to root out that they lose confidence in the stock market. If this is doubted, we need only consider past stock-market darlings including ZZZZ Best, Enron and, more recently, Lehman Brothers (OTC:LEHMQ). These were all once high-flying stocks, and the financial "detectives" that we know as short-sellers revealed with each that the proverbial emperor had no clothes.

Far from undermining confidence in the cleanliness of markets, unfettered short-selling limits the number of investors that will buy into what is false. On the other hand, rules put in place that would slow the death of fraudulent or insolvent firms will mean more, rather than less, in the way of investors will be ensnared by false market signals.

More broadly, the economy itself will suffer for ineffective stewards of capital essentially having their executions delayed. Rather than boosting confidence in either the economy or the stock market, efforts taken by regulators to make that which should be transparent opaque will slow the economy and market healing process that results from poor managers being starved of capital in favor of those who might oversee it more effectively.

If there's a silver lining to the SEC's silly decision, it's that markets are global, and if U.S. regulators are too immature to understand the importance of price discovery and the short-seller's role in it, other global markets will take the trading volume that our SEC intends to repel. Prices are prices, and if we're not willing to accept reality, investors in global markets will make sure we do anyway.

What perhaps can't be fixed is the growing belief that as a nation we're not serious. The SEC's decision is a reminder of the latter, and if investors head for the exits in droves from the great market that is the United States, those who can't comprehend the withering interest need look no further than Washington in seeking a better understanding for why.

About John Tamny:
Mr. Tamny is a senior economic advisor to
Toreador Research & Trading, columnist for Forbes and editor of Mr. Tamny frequently writes about the securities markets, along with tax, trade and monetary policy issues that impact those markets for a variety of publications including the Wall Street Journal, National Review and the Washington Times. He’s also a frequent guest on CNBC’s Kudlow & Co. along with the Fox Business Channel.