I criticized Barack Obama's call to go after market manipulators like those rumored to have brought down Bear Stearns last month. My contention was that stricter enforcement could have a chilling effect on the dispersal of good information. But regulators seem to be taking the issue seriously. In congressional testimony earlier this month, S.E.C. boss Chris Cox strongly implied that the agency was looking into the Bear matter.
Itay Goldstein of Wharton and Alexander Guembel of Oxford look at a hypothetical situation where a company is looking to invest in a project with an outcome that is unknown. In a world where investors have special information about the potential payoff from the project, then if we see the stock price rise after the announcement, we have a good idea that the outlook is good. On the other hand, a price decline means that the project is probably a bad idea.
But in the real world, there are investors who don't have any special knowledge about such projects. If they chose to buy the stock on this non-information and the project turns out to be a bust, then investors lose out.
However, if investors start shorting the stock on no information and the stock declines, the company may read this as a sign that they shouldn't take on the project, even though it would ultimately have been profitable.
"On average, this is the wrong decision and will in itself reduce the value of the firm," the authors write. "This enables the speculator to cover his short position at a lower cost and make a profit. Due to the nature of this strategy, we refer to it as manipulation."(emphasis mine)
Of course, it's important that no one know what the speculator is up to, Goldstein says. "If everyone in the market knows that this hedge fund is trying to manipulate [the stock], then it will have no effect." It is essential, he adds, that the market's other players think the manipulator bases his decisions on insight even if he does not.
The authors argue that regulations aimed at stifling incentives for manipulation through short-selling can improve market efficiency.
The S.E.C. already has some restrictions against selling short, but Goldestin and Guembel's analysis implies that further tightening may be needed. This can only be music to Patrick Byrne's ears.