Short Selling Is Not Evil

Nothing surprises me these days. But that doesn’t mean it doesn’t concern me. This short selling ban is, without question, the scariest thing to come out of the whole mess.

And it is not that I don’t have perspective. The meltdown of three bulge bracket I-banks and the largest insurer in the world is pretty damn scary. But at least it wasn’t the government’s doing. You see, I have a far-fetched and unfashionable faith in this whole free-market thing. I realize the effective shutdown of credit and resulting lack of liquidity would have been devastating to the economy, possibly sending us in to depression. But how in the world does the banning of short sales on the stocks of these financial companies promise resolution? (Answer: it doesn’t, but makes the politicians look good)

Here are a few things I know for sure. First, hedge funds now dominate a huge portion of the stock market in this country. In order to hedge, they use short selling. Without the ability to do so – even if only for a limited number of stocks – their portfolios will be in chaos and this is not right.

Second, short selling is not evil. It is necessary. Typically the only ones who ever gripe about it are the ones frustrated their stocks aren’t going up. But even if it were evil, it was the way the game was played up to this point.

Third, if the bulls really were right, then they would eat the shorts’ lunch. The shorts would drive the price down and at some point, I, the fundamental value investor, would say "Holy cow this stock is cheap!" and buy it up. But we can’t do that with the financials because there is a good chance that they really are worthless.

Fourth, the act of the government telling me these stocks are not worthless does not change their intrinsic value.

Maybe there is a legitimate reason. The most logical one is that some short sellers are spreading false rumors. Well, this is called fraud and it's already illegal. If the SEC wants to go after any idiot that may be doing something like this, they can have at it. But banning short selling across the board is not an appropriate reaction. Jim Cramer articulated a different possibility, that short selling is being used as financial terrorism. I guess the theory is that some Middle East terrorist syndicate is coordinating a series of shorts, knowing that it would cause chaos in our markets. I guess that’s plausible.

Most important, though, is that the SEC itself has yet to justify the attack on shorts. I have yet to hear anyone explain how it is the stock prices of the financial firms that threaten the stability of our economy. I would argue that the stock prices, while reflective of the underlying firms, are not the cause of their troubles. The cause of their troubles lies in the credit market, credit default swap market and/or the mortgage backed securities market. But NOT the stock market. In light of this observation, the only conclusion I can draw is that Washington doesn’t want to see stock prices fall, regardless of the underlying fundamentals of the companies behind them. This is not a free market attitude.

Call me ivory-tower, but it was my understanding that short selling helps in this process we call price discovery, the driving force behind the efficiency of the capital markets. Without shorts, one must own the stock to take a bearish position. With it, the bears and the bulls can battle it out and reach a consensus called the market price. The sad truth is, the financial companies whose stock prices are getting hammered have financial statements that nobody trusts, giving the shorts as much justification in betting against them as the longs would have in betting in favor of a stronger company.

Moreover, the inability to short leads to market bubbles – the very problem (albeit in a housing market) that got us in to this mess to begin with. Short sale constraints are the classic limit to arbitrage. If bearish investors can’t take bets to offset the bulls, prices get completely out of whack. For an example of this see my old posting about the Palm/3Com situation from several years ago.

Herein lies the biggest hypocrisy of all; the SEC seeks to thwart stock market manipulation by short sellers, yet by interfering with investors' ability to short the SEC is itself manipulating stock prices far more than any hedge fund could ever hope to. It should be obvious the market’s rally on Thursday was not “hope for a bailout” as the headlines read, but shorts covering before it was too late. Well on Friday morning it was already is too late. The logic behind forcing investors to purchase stocks (cover shorts) at grossly inflated prices could only be understood by Karl Marx himself. These investors can’t even ride it out.

Of course there will be unintended consequences of this nonsense, but there is no excuse for the SEC not anticipating them. For one, hedge funds will be forced to cover their short positions in certain financials, so will they sell the other financials in their portfolio not among the 799 on the list since those positions may no longer be hedged? Is it fair to force investors to abandon an investment just because its strategy is now prohibited by the SEC?

Chairman Cox says “The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets.” Well if changing the rules for basic functioning of the market is one of the weapons in his arsenal, perhaps we need to re-think the language of the SEC Act of 1934. While I don’t have this portion of the code committed to memory, I have yet to hear anyone cite the section explicitly giving him this authority.

Cox’s most hilarious quote of the day is probably the following, “The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets.” Gimme a break. Tell me it's terrorists, tell me it's market manipulators, but don’t tell me this will bring equilibrium.

I am convinced this is political because here is what I've been told. Hedge funds are evil. Short sellers are evil. Even the SEC is evil - and that was before it decided to ban short selling. (I am referring to McCain's comment that Cox should be fired for not regulating the markets sufficiently in the last few years. ?? Cox should be fired, but not for what he did last year or the year before...)

Ever notice how every time the media mentions short selling that mention is accompanied by an explanation of what short selling is. You know how it goes. "Short sellers take bets that a stock price declines, hoping to profit from its fall." Why does this need to be explained every time? Because they think we are idiots. Actually, that's not right. They are idiots and assume we are idiots as well. This works well for politicians, because they can run around blaming everything on hedge funds and short sellers and the average American won't know any better. Isn't that about right?