Hooray for the bullshit-callers

ASIC, one of our main financial markets regulators, has today declared that short-selling is a “legitimate business in the market”. Good on them. Markets need short-sellers, far more than most people realise.

The reason is that financial markets are markets in ideas – ideas about what will be valued in the future. And so they need people who are able, every so often, to loudly yell “Bullshit!”

It was short-seller James Chanos who called “bullshit” on Enron in 2001. And it was short-sellers who identified the problems with the US mortgage market a few years later, a story well told in Michael Lewis’s book “The Big Short”. In both cases, the short-sellers explained why the rest of the market was wrongly over-valuing those investments.

If only there were more such people, Enron and the US mortgage market might both have failed earlier and done far less damage.

In fact, if financial markets are to operate calmly rather than in the boom-and-bust mode that does so much damage, short-sellers should be encouraged. In the absence of short-sellers, markets will be full of people with an incentive to overstate the merits of particular investments.

Calls to limit short-selling featured prominently in the 2008 crisis, but they go back to at least the 1600s. People making money out of selling over-valued investments don’t like seeing their tall stories exposed. Their objections tend to be effective, because not enough people value the role the short-sellers play.

Bullshit in financial markets is too dangerous to be left alone. People need to call it early and often. We need more short-selling, not less.

Footnote: The only reason I’ve posted this is that it seems to be an extreme minority opinion. Almost everyone I talk to sees short-selling as sinister. Does anyone know why?

About David Walker

David Walker runs editorial consultancy Shorewalker DMS (shorewalker.net), editing and advising business and government on reports and other editorial content. David has previously edited Acuity magazine and the award-winning INTHEBLACK business magazine, been chief operating officer of online publisher WorkDay Media, held policy and communications roles at the Committee for Economic Development of Australia and the Business Council of Australia and run the website for online finance start-up eChoice. He has qualifications in law and corporate finance. He has written on economics, business and public policy from Melbourne, Adelaide and the Canberra Press Gallery.
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Patrick
Patrick
10 years ago

I suspect it won’t be an extreme minority opinion on this site. I certainly agree.

Nicholas Gruen
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Nicholas Gruen(@nicholas-gruen)
10 years ago

Generally speaking I agree too. But it’s not quite as simple as that. There’s a fair bit of evidence now that the intuitively appealing model of speculation – Milton Friedman’s model – namely that speculation is overwhelmingly good, is wrong. Momentum trading – which is what a lot of speculation is – can be very destabilising and can in fact drive out ‘fundamental speculators’ with insufficiently deep pockets.

Of course not all short sellers are speculators – the ones you mention are undoubtedly healthy – and anyway, if the problem is speculators, it’s as much with those speculating on the upside as the downside.

In the presence of strong momentum trading, short selling can make some nasty things happen that need not happen – like yelling fire in a crowded theatre.

Anyway none of this explains why short selling is so demonised, or justifies banning it. I’m generally sympathetic to what you say. But if it can be done efficiently (a big if) the market would probably be more efficient with less, rather than more speculation than we have now.

Stephen Bounds
10 years ago

I have no financial background, so I can only provide my outsider’s opinion.

The original purpose of a stockmarket was to enable an easy and flexible way to raise funds for a company from a far wider pool of funds than would be possible by soliciting individual private investors.

As such, the basic concept of owning a share is a simple vote of faith: here, take my money, and make more money with it. Importantly, it is a compact between an investor and the company.

Short-selling is a derivative by nature (if not as commonly understood) in that the transaction ceases to be about the company and instead becomes about the investors. Short-selling is a bet: investors will be selling their shares at a lower price tomorrow than they are today.

This encourages and in fact rewards psychological manipulation of investors, misinformation, and short-term outlooks. Most damningly of all, short-selling makes the act of forcing a company go broke a positive thing for a minority at the expense of all those who benefited from having a productive company — employees, customers, suppliers and the like.

In both Enron and the US mortgage market, the root of the problem was that senior employees in companies made deliberate misrepresentations for their personal profit. The perceived risks and penalties for misbehavior were not sufficient to make these people act in the expected manner.

Allowing short-selling is like a privatised militia against bad financial behavior where the motive to act is purely profit-based. But personally, I would rather have better cops on the beat.

Mike Pepperday
Mike Pepperday
10 years ago

I presume that the point of the government banning short selling in 2008 was to prevent a sudden influx of short sellers, out of fear that it would make the crisis worse. If this interpretation is correct then it would seem to follow that short selling would be all right if it were as normally practised as going long. Then there would be calmer markets as David Walker says. Therefore, we need more short sellers.

But I don’t see it happening. Many have expatiated on the peculiar psychology of share trading; here’s my tuppence-worth. The overwhelming majority of shareholders, whether traders or investors, are hoping their stock will rise. Perhaps if they were perfectly rational they would go long and short in roughly equal numbers but it seems to me to be psychologically contradictory for the share holder is essentially an optimist, not a pessimist.

You could argue that the short seller is optimistically rubbing his hands together in anticipation of a win but, overall, we prefer the market to rise for that spells prosperity. Short-selling is like betting against the home team. Most optimists aren’t going to do it. That may be what is “sinister” about it.

It therefore follows that we will only see large numbers of short sellers in times of crisis and of course that isn’t crying a warning “bullshit” for by that stage the pile is steaming for all to smell.

Short and long are not symmetric. I did it just once. I aged about ten years in two weeks, two weeks of anxiously listening to every radio stock market report. I quit then, without damage. In more recent times I worked out my own “chartist” philosophy but (like all chartists, I think) applied it only to rises not only because I wanted to sleep at night but also because I think it correct that stock prices fall much more quickly than they rise.

Perhaps that tendency to steeper falls than rises is itself a consequence of the lack of the calming influence of short sellers.

Patrick
Patrick
10 years ago

Stephen, that doesn’t seem to be right – I would have thought that short-selling is most certainly about the company; it usually works when the shortseller knows something about the company that most investors are not factoring in. It is easy to forget that short-sellers can lose money very easily.

It also seems quite wrong to assume that short-selling follows the market, quite obviously the real money is in leading it! Finally the point about there being more short-sellers in a crisis doesn’t seem to add much, there are more bulls in a run, too.

Being anti-shortselling for your reasons appears to amount to being pro-bubble!

Pedro
Pedro
10 years ago

“it usually works when the shortseller knows something about the company that most investors are not factoring in”

Patrick, that sounds suspiciously like the other hideous crime of insider-trading!

The thing I wonder about is funds, which owe duties to their members, lending shares to the shorters. That is something I don’t get. It would seem to be clearly in conflict with the interests of the investors in the funds.

conrad
conrad
10 years ago

I can add to Patrick’s comment about Stephen’s comment that whilst “Short-selling is a bet” is no doubt true, I assume that essentially all share-trading (indeed investing) is a bet, and that there are simply different ways to makes bets. The actual level of risk, for example, might be similar if you use a highly geared method for buying a stable stock (or property), no gearing on a risky stock, or options to buy/sell stuff in the future depending on what they happen to be. In addition, as a mug punter, I’ve personally never cared about the companies I have stocks in, and I don’t really see that I have any greater relationship with them than I might have with, say, a bit of gold I’d bought for investment or the cash in my bank account that pays interest. If I thought I could make money from selling them out tomorrow, I would, and I don’t see anything wrong with that. Given this, I see the transactions I make as entirely about me and not the company no matter what type they are (especially because my holdings are so puny that I will never have any influence at all over anything) — isn’t that the idea of investing for most people?

Mt Isa Miner
Mt Isa Miner
10 years ago

Following from Pedro’s post: I want to comment on the lending by the company of the company stock for the espressed purpose of shorting the company, for a fee, a low % but the low % gathered many times does add to the company bottom line and makes everyone happy. This is as far as I know NOT seperately disclosed! Such actions are to my mind a clear breach of fiduciary duty owed to teh shareholders.

I fail to see how company boards/CEO are not pursued for these breaches per se AND for any resulting losses in the bear markets. Yes I have heard the sop that it all comes out in the long run- well that is no good at all to some poor B* who has to collect his Super in the next 12 months and crystalise the loss right there and then; or an individual investor.

Step up ASIC.. Small Shareholder rights in the Corporations Acts…crickets…

This is not a comment on the uses of shorting in the market in itself.

mozzie
mozzie
10 years ago

There’s a more general objection to so-called “naked shorts” (without recourse to physcial) among the more ethical traders. That’s what was made illegal under ASic rules in 2009 http://www.asic.gov.au/asic/asic.nsf/byheadline/08-204+Naked+short+selling+not+permitted+and+covered+short+selling+to+be+disclosed?openDocument.
It’s not clear whetehr the Europeans are banning all short selling or just naked shorts

Stephen Bounds
10 years ago

I can add to Patrick’s comment about Stephen’s comment that whilst “Short-selling is a bet” is no doubt true, I assume that essentially all share-trading (indeed investing) is a bet, and that there are simply different ways to makes bets.

See, this is where I think the stockmarket has become perverted from its original purpose. Bear in mind I’m completely ignoring any economic arguments here; I’m simply thinking about the social compact involved in investing.

As an illustrative metaphor, imagine that I believed Cadel Evans had a chance of winning the Tour de France, but he needed funds to purchase his bikes, support car, entrance fee, etc. If I invest money in Cadel Evans in exchange for a 10% stake in any winnings, I am saying “I trust you, I believe you can win”.

If I bet on Cadel Evans winning or losing, that does not impact on his ability to prepare and execute on his strategy for the Tour one jot. But there’s now an incentive for me to bribe or sabotage the other entrants in the race and distort the outcome if betting were not allowed.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
10 years ago

David, regarding your challenge, I can’t meet it properly – and I am certainly not trying to paint myself in the camp of people who want to ban short selling, but it does put me in mind that short selling is part and parcel of the market manipulator’s tool book and does make that transition from the stock market being a source of funds for building things to being a casino. Of course being a casino can be a way of making the market an even better vehicle for marshalling savings to worthwhile investment tasks, by being more unforgiving of dumb ideas or bad management.

But we do need to be a bit sceptical of our own cleverness here.

At the bottom of Keynes’ vision of the economy is a kind of mystery. Why, in the face of essentially unknowable risks do entrepreneurs take major risks with their money? It’s quite a riddle. Of course they do it to turn their money into more money. But they also risk making less, and they simply can’t be confident of the odds. They do it for all sorts of motives – greed, the struggle for esteem, compulsion, a ‘vision’ of the thing they’re investing in, which can be a kind of altruism in some ways even if it’s not acknowledged as that, and they do it from habit. Tigers eat other animals and investors invest.

But a lot of investment is not all that rational – when you consider that risk aversion makes sense for individuals and for the holders of large amounts of money, it doesn’t take much risk aversion to render large bets bad bets at least ex ante.

Seen in this light, it’s a kind of mystery what keeps it all going, a secret sauce or mortar holding the bricks together like civil society holds this dual trick we’ve managed in the modern world of markets and representative democracy. We don’t really know where it comes from, or how to build it – though freedom of association is part of the mix that does it.

But radical market freedom (particularly the power of the plutocracy) can threaten civil society – and I think is doing that in the US. By the same token, though I’m not endorsing a ban on short selling in a sophisticated market like ours, it is possible to see the disfavour towards short selling as being in the tradition of numerous policies which have been quite effective in promoting industrial development in less developed countries in which a potential allocative inefficiency is incurred for the potentially much greater good of the promotion and development of productive efficiency.

observa
observa
10 years ago

I have no problem with short selling provided the short seller has to pony up the readies for the cost of what he doesn’t have at the time. Putting the funds upfront in a trust account should do the trick.

observa
observa
10 years ago

Or a lien on the farm equity if the farmer is promising to deliver a crop at an agreed price down the track, etc.

Mike Pepperday
Mike Pepperday
10 years ago

Nicholas at #13: “Why… do entrepreneurs take major risks with their money? … they do it to turn their money into more money. But they also risk making less, and they simply can’t be confident of the odds. … they do it from habit. Tigers eat other animals and investors invest.

“But a lot of investment is not all that rational… it’s a kind of mystery what keeps it all going, a secret sauce…”

You might call it habit but it’s more like the tiger: they’re made that way.

A days ago at

http://clubtroppo.lateraleconomics.com.au/2011/08/08/matt-yglesias-left-neoliberalism/#comment-438730

I suggested there are just two basic sets of values which I suggested could be called the “conqueror” set and the “prophet” set (but don’t get hung up on labels). I gave a brief list of each. People can adhere to either of these conflicting sets and their worldview will be coherent. I was talking there of their resolution and showed that it required a whole new worldview (hierarchy).

It is that first type, the conqueror, who plays the stock market. It is an activity which ticks their boxes as I listed them. Another attitude of theirs which I didn’t list, is optimism regarding the material world. The world is their oyster – or more clearly, a skill-controlled cornucopia. You can only win it if you’re in it and you reckon you can beat the odds.

The secret sauce is that we all have to make sense of the world and there are only a few ways to do it. One of them is the conqueror’s way. It is a view which holds, inter alia, that material risk is opportunity. (As I said above, it is this built-in optimism that they have to overcome to sell short.)

As a reality check, think of all the academics you know who play the market. It is not surprising since they have the perfect situation to be stock traders: a free online computer, no one looking over their shoulder and probably more brains than most traders. Well, actually I don’t know a single one. The conqueror mentality just does not go into academe.

I am sure you are right in saying too much can damage civil society – too much of any of the mindsets.

conrad
conrad
10 years ago

“Well, actually I don’t know a single one. The conqueror mentality just does not go into academe. ”

I know some, and some that have done very well out of it (and others that have made money through other speculative stuff). The problem now is that (a) short term trading is a losing bet against algorithms — can you beat the computer at chess and go? If not, then I don’t see why you would expect to beat an algorthim that some of the smartest people in the world have thought of (it’s not like these are developed by the stupid amongst us); and (b) apart from obvious strategies that everyone can use (e.g., buying a range of things in the top 200, buying into different funds etc.), even if you are really smart, you’d be deluded to think that even if you could devote 30% of your time to it, you would beat someone that can devote 100%. So I would think that common sense can trump your conqeurer mentality — why not just use government approved scams like negative gearing?

JC
JC
10 years ago

Shorts are the investors friend, always have been and always will be. They are the people that ring the bell when the management of a company is acting dishonestly and unethically.

Who says they always make money? It seems to me that whenever shorts are discussed it’s always assumed they’re profitable. They don’t and in fact often get their heads handed to them along with their private parts.

I’m a full time trader and will always look at the short position in a stock as one of my first checks and will continue looking at the level throughout the time I own a stock.

In fact one of the best, quickest ways of making money is chasing the shorts after a big move.

There are search engines now that allow a trader to search for the most heavily shorted stocks.

Take this stock that I’m heavily involved now.
Short as % of Float 32.2%

WNR is heavily shorted for a number of reasons. It’s carrying a load of debt (around $1 billion), which the shorts think is too high for the industry. Refining is an extremely volatile industry with the crack spread (spread between unrefined and refined crude) at historic levels. The shorts also think it’s 2008 all over again with the way the stock market is behaving.

However they’re wrong. The windowmaker (crack spread) is going to remain wide for a long time for structural reasons and the firm, along with a bunch of other refiners in the Cushing Texas area, are going to be printing money.

When the shorts see the error of their egregious ways this stock could make it to 40 bucks a share. When the shorts finally catch on this is going to be painful as there will be an almighty rally of biblical proportions.

My point is don’t always think you can make money shorting stocks. in fact it’s really a limited bet in raw probability because you can only get to zero with a short whereas the upside is theoretically unlimited.

Anyways there are ETFs that allow people to take leveraged risk up to 3 times the value of the stocks held in the ETF. see here. These hybrid “stocks” can be short or long.

The problem now is that (a) short term trading is a losing bet against algorithms

Conrad, you can now buy decent alogs for 500 bucks a year that work. They’re good, but you still have to use your head.

observa
observa
10 years ago

Piffle! Shorting is a form of money creation as the US housing bust showed with a giant fallacy of composition. Shorting involves funny money creation as we’ve seen with buyers punting on house price rises when as it transpired they had insufficient equity to satisfy their short positions when the bell tolled and their risky margin loans were called in.

Now if real savings(ie forgone consumption) had been borrowed to purchase homes the lender would have been much more circumspect about the borrower’s ability to repay and their security (ie equity), in order to pass that on to the seller. It may well be that the seller is often the lender back to the financial lender in turn, albeit the procceds of the sale are spread with the proceeds of other sellers among a host of other sellers (ie mortgagees). That process merely diversifies risk but fools gold puts the whole edifice at risk as we’ve seen whereas with real gold the dangerous price boom could never have got off the ground. That only leaves very isolated default for the risk/return system to accommodate.

As I said, no problem shorting shares if the current price in real savings must be ponied up. Instantly you can see that in composite if omniscient shorts are to perform their vital economic role, then to the extent they wish to borrow real savings to facilitate that, some selling may occur to enable them to, thereby negating the very shorting opportunity. Too many fools gold short fans here for mine, but that’s because they live in a fools gold world and can’t see beyond it.

observa
observa
10 years ago

oops…among a host of other buyers (ie mortgagees).

observa
observa
10 years ago

Or the shorter observa- Why did Enron occur in the first place and how did the VW shorts do and why?

observa
observa
10 years ago

And come to think of it you just convinced me to add another rule to my fools gold or gold rules world of investing-
1. The higher the return the greater the risk.
2. Don’t put all your eggs in one basket.
3. Never put yourself in a position where you have to sell.
4. Gummint prudential regulatory authorities are professional mourners paid out of your taxes to come and wail with you if that makes you feel any better.
5. If anyone tells you they have a sure thing, system or algorithm, they’re lying because if they really did they’d be sunning themselves in the Maldives with their feet in a bucket of champers, not telling you and lowering their odds.

Pedro
Pedro
10 years ago

If risk aversion really did make sense we’d probably have evolved into different creatures, vegetarian for one thing!

observa
observa
10 years ago

Along with the vegy mob you hanker for eyes where your ears are like ruminants Pedro but me I’m sticking with hunter eyes facing forward and a well planned risk aversion strategy with the Weber ;)

Pedro
Pedro
10 years ago

I was arguing against NG’s keynsian insights.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
10 years ago

Pedro,

Trust me, risk aversion is real. Otherwise you’d put all your money on a startup punt on the stock-market.

Pedro
Pedro
10 years ago

Yes it is, a quick look at my share portfolio will support your argument, but taking risks is also real.

“At the bottom of Keynes’ vision of the economy is a kind of mystery. Why, in the face of essentially unknowable risks do entrepreneurs take major risks with their money? It’s quite a riddle.”

My simple suggestion is that we predatorial types evolved to take dangerous risks and so the fact that we do it in the bourse as well as the savannah is perhaps not that much of a mystery.

observa
observa
10 years ago

I guess Austrian economics simply makes the connection that busts like the GFC are really just a whole host of people and their Govts short on real forgone consumption. There’ll be an inevitable closing out of that overall position although when the stampede for the exits will occur is one for the historians. However this time round so many missed the unprecedented demographic input which made the bust such a doozy. That same demographics which created unprecedented stagflation in the seventies and why there’s some considerable unwinding to go yet.

Mike Pepperday
Mike Pepperday
10 years ago

Conrad at #17. I wasn’t particularly talking of short selling – just responding to Nicholas’s puzzlement about why anyone risks money. (There is a particular kind of person who is suited to it.)

Here is a fine column connecting riots, Murdoch, and short selling:

http://www.independent.ie/opinion/columnists/gene-kerrigan/gene-kerrigan-rulingclass-rioters-dont-wear-masks-2847864.html

It emphasises that short selling takes specialised knowledge and skill.

murph the surf.
murph the surf.
10 years ago

The scenario played out in the Gene Kerrigan article makes me wonder though isn’t the situation he describes actually illegal?
Is naked short selling and rumour mingering allowed to happen or does this matterfall into the “too hard” basket for regulatory authorities?
My impression was that proprietary traders with the credit can do a lot of damage and their bonus system rewards the profits so delivered.
Or is that just a City myth?

Mike Pepperday
Mike Pepperday
10 years ago

Murph – Short selling is normally legal. As for rumours – the stock market thrives on them.

If respected trader Murph-the-Buffett goes short for $100m worth of Southward Gasp stock and this is known (and why shouldn’t it be?) no rumour might be necessary. People figure Murph knows something so they sell their SG holdings and the price drops and Murph can buy it cheap to fill his contract and his pocket. And as other posts have pointed out, it might all be very reasonable. Murph has done his homework (read the annual reports, judges that the field that SG operates in has a poor outlook) so Murph’s self-interest sends a cautionary message to the market.

Going long is not symmetrically opposite. If Murph buys $100m of Northward Ho then others who respect his judgement may buy it and the NH price will rise. But Murph doesn’t have to do anything else; he might hang onto those NH shares for years. NH gets the benefit of a high stock price and everyone prospers. That is not the case with going short where only the smarties who saw a company in trouble can prosper.

JC
JC
10 years ago

Going long is not symmetrically opposite. If Murph buys $100m of Northward Ho then others who respect his judgement may buy it and the NH price will rise. But Murph doesn’t have to do anything else; he might hang onto those NH shares for years. NH gets the benefit of a high stock price and everyone prospers. That is not the case with going short where only the smarties who saw a company in trouble can prosper.

Mike
It’s not symmetrically opposite only in so far as you bang up against zero with a short while the top is theoretically unlimited, consequently the odds are lessened.

It’s not necessarily smarter to be short, Mike.

Look back before 2008 and short only funds were generally a sorry bunch after a 25 year bull market. And as for doing research…I hope its does equally on the long side too.

observa
observa
10 years ago
Alfred Nock
Alfred Nock
10 years ago

The goal is excellence in resource allocation, and for this we need excellence in share pricing. This implies that we must outlaw short-selling just as quickly as we can and instead legalize-but-regulate “insider-trading.” Superb insider-trading regulations, will bring more information to share-pricing then short-selling ever could. And the reality is that short-selling, in current practice, is merely a hateful Trojan Horse for the disastrous rort of broker-share-pyramiding. One of the most costly practices to society over the last ten years. ANY phantom supply distorts pricing and therefore resource allocation. Phantom supply ought never be tolerated, even on faux-libertarian grounds. The reality is that the regulators lack the will, independence, conscience, and understanding to allow short-selling while eradicating naked short-selling. So the entirety of short-selling has to go.

JC
JC
10 years ago

For anyone that thinks shorting stocks is a one way ticket to a Beverly Hills Mansion.

Looksee at this.

Bank America was one of the most heavily shorted stocks for the past few weeks. Grave diggers were already measuring up for the hole. Rumors were flying around that the Fed was about to close down BAC. It fell around 30% in about a month.

This mornings news before the opening bell:

http://dealbook.nytimes.com/2011/08/25/buffett-to-invest-5-billion-in-bank-of-america/

Buffet handed a juicy insider deal sent the stock up 23% in the pre-market and those undertakers are now measuring caskets for the shorts.

Alfred Nock
Alfred Nock
10 years ago

That not everyone makes money on shorts is not really relevant is it JC. Try not to distract people.