Tuesday, April 25, 2017

Stock Market: Should Short Selling Be Illegal?

(Drivebycuriosity) - There is a cult around short sellers. These people are betting on falling stock prices (by going short or shorting). They borrow stocks from a bank and sell the shares immediately  in the hope that stock prices will fall and then they could buy back these stocks for much less.

Famous short sellers like Jim Chanos, Bill Ackman, Whitney Tilson & Carson Block are celebrated in the New Yorker, Bloomberg, Business Insider and other media (bloomberg). Some are treated like rock stars (features). The influential magazine The New Yorker claims, "shorting helps counterbalance investor overconfidence, corporate puffery, and Wall Street’s inherent bullish bias" ("In Praise of Short Sellers" newyorker). The magazine also declares that shorting "contributes to the diversity of opinion that healthy markets require".

                                                         Feral Hogs

Does it? The graph above shows that short selling (measured as the so-called "short-interest") has been shrinking during the current bull market for stocks. It looks like short sellers had to cover their bets (and to buy back) as stock prices have been climbing in order to limit their losses - which could amplify the upwards trend. But history shows, that short sellers are getting much more active when stocks are falling. For instance the correction in early 2016 inspired George Soros and many others to short the US stock market (driveby). As a consequence the short sellers aggravated this dip. But they had to buy back as stocks recovered later in 2016.  So, short sellers are amplifying the stock market fluctuations instead of smoothing them.

History shows that short selling gets more intense when stock prices are in downwards trend - which  could lead to a snow ball effect. In the recession of 2008 and early 2009 short selling was a viable business model. Hedge funds and other speculators were betting on a meltdown of the market and were shorting it. Massive shorting accelerated the fall of the stocks which intensified the pessimistic sentiment and inspired so more short selling, creating a snowball effect. It worked temporarily as self-fulfilling prophecy.

After the bankruptcy of Lehman Brothers, which brought huge gains for short sellers, groups of short sellers tried to repeat their success. They attacked everyone who seemed vulnerable, especially the banks. Federal Reserve member Richard Fisher (Dallas Fed President) described these groups as " big money" that "does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they go after it"  (marketwatch ).

These massive bets against banks and many other companies destroyed not just the trust into the attacked firms, these bets destroyed the trust into the whole economy. Bankruptcies and tumbling stock prices seemed to confirm those attacks. Thus the stock market got into a downward spiral which paralyzed the whole economy. Companies ceased investing & hiring, the recession was on the brink to turn into a disaster like the great depression of the 1930s. The destruction of trust lead to spiral of pessimism that almost sucked the whole economy into the vortex of a depression. In spring 2009 massive stimulus programs (QE) and a zero interest policy stopped finally the downward spiral.

                                                         Rumors & Allegations

Even in a sound economy can short sellers do a lot of damage. This is described in the James Bond movie "Casino Royale". A villain, named "Le Chiffre" shorted stocks of an airline and ordered then an assassin to bomb a big new passenger plane in order to destroy the whole company and make their stocks worthless. Just fiction? Not really. Last week in Germany a man was arrested for a bomb attack (reuters). He had purchased put options on shares of the soccer club Borrussia Dortmund, which gave him the right to sell these shares to a certain price. Then he detonated three bombs that targeted the club`s team bus in the hope of forcing down the club's share price and making a profit. "If the shares of Borussia Dortmund had fallen massively, the profit would have been several times the initial investment," the prosecutor's office said, adding that such a slump could have resulted if any players had been killed or seriously injured.

All short sellers benefit from falling stock prices. Thus they have a natural interest that the business of the shorted company fails. Even if short sellers do nothing illegal they can inflict a lot of harm by spreading rumors & allegations about the shorted company- a practice dubbed “short and distort”. This way they can ruin their reputation and irritate customers, creditors, investors and employees and so inflict harm onto the company.  Often short sellers appear on TV or they give interviews after shorting to "explain" their case. Sometimes they conspire to torpedo share prices in “bear raids.” With false allegations they can  destroy good companies and cause people to lose their jobs. And short sellers are not regulated the way Wall Street analysts are, so they aren’t as accountable (bloomberg). 

Short sellers are often very powerful and exert a large influence on the stock market.  Bill Ackman,  a hedge fund billionaire and CEO of the hedge fund Pershing Square Capital Management, has been betting big against Herbalife, a producer and seller of nutritional supplements, for years. In December 2012 Ackman revealed that had massively shorted stocks of Herbalife and then started bad-mouthing the company.  "To bring the stock down Ackman did not just use his huge reputation as a billionaire hedge fund manager and media star. Ackman´s team has organized protests, news conferences and letter-writing campaigns in California, Nevada, Connecticut, New York and Illinois, against his victim " wrote the New York Times (nytimes). He also pulled the political puppet strings and got support from leading politicians including a senator.
Short sellers don´t invest, they don´t support economic growth, quite contrary, they punish companies who´s management thinks long term and invests into the future (which often reduces gains in the short term or even causes losses). Short seller can discourage CEOs to invest and to create new jobs because the implied costs could provoke attacks by short sellers. Short sellers could slow down economic growth  - and they make any crisis worse. I think these are enough reasons that short selling should be illegal or at least constrained and scrutinized like the work of analysts.

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