Don't Sell Yourself - Or The Bank - Short

Before dawn on the East Coast of the U.S. this morning, the Securities and Exchange Commission (SEC) issued a temporary ban against short-selling. Specifically, the SEC's statement said that it is halting short selling on 799 financial stocks. The ban is designed to be temporary, with an initial effective period of 10 days, and a possible extension to 30 days.

Short selling is really not that complicated. It involves betting on a decline in a stock's value, by selling stock at a certain price, in the hopes of buying it back later, hopefully at a lower price. Look at it as the reverse of the typical set of transactions, where one buys a stock, in the hope of a price increase, and a subsequent sale of that stock at a higher price. Instead of "buy low, sell high," the short seller wants to "sell high, buy low."

The art of selling stock short is about as old as the markets. In the 19th century, when our stock markets resembled the Wild West, and stock price manipulation was the order of the day, short sellers and those who owned the company's stock often waged fierce battles. Whenever there was a large short interest in a stock (many shares had been sold short), others would try to "squeeze the shorts" by "cornering" the stock, i.e. getting their hands on all of the available stock of the company in question. Consider that a short seller was selling stock that he/she didn't own. At some point, he/she must buy it back. If someone would corner the stock, the short seller would have no option but to pay whatever price the owners of the stock wanted in order to buy back the stock, usually incurring enormous losses in the process. "Squeezing the shorts" was as painful as it sounds.

Daniel Drew, a legendary (and much-reviled) stock trader in the latter part of the 19th century, was known primarily as a short seller, but was involved on both sides in several corners and attempted corners in his time. Supposedly, when he was on the long side of the market, and in the process of extracting a terrible price from short sellers, he would recite the following witty verse:

"He who sells what isn't his'n,

Must eventually buy it back, or go to prison."

Selling stock - or any security - short has never been for the faint of heart.

I understand that the SEC believes that it is acting in the public's interest in banning short selling in certain stocks for a little while. I disagree.

Once again, it appears as though we are falling into a trap, by making short sellers the scapegoats for the nerve-wracking declines we've witnessed in the shares of financial company stocks.

Blaming the short sellers for all of society's ills is nothing new. For the past two hundred years, officers and directors of companies whose stocks took a beating would often blame the decline in price on the short sellers. In the 19th century, they'd refer to it as a "bear raid."

Speaking in indignant tones, the company leaders would say, "Amalgamated Tobacco and Snuff is as robust an enterprise as it has ever been, with ever-rising profits and ever-brightening prospects. The recent weakness in our shares is the result of the scurrilous acts on behalf of the unscrupulous bear camp. Despite the worst efforts of these scoundrels, AT&S will prosper."

Or something like that.

Meanwhile, in a few weeks, or months, the public would find out that the company was in fact experiencing deteriorating business conditions. Sometimes, the officers and directors of the company were secretly sticking their hands in the company till. ("T'was an act of desperation, your honor. I was short of greenbacks, and Mabel needed a new gramophone.")

This kind of scenario has repeated itself on many occasions over the years (maybe not the gramophone part). Short sellers have often been blamed for hurting a company's stock, when in fact, the real issue was with the company's fundamental business.

Anyone who is interested in an interesting book on the subject, from a short-seller's perspective, should read "Fooling Some of the People All of the Time: A Long Short Story," by David Einhorn. In the book, Einhorn, who runs a hedge fund called Greenlight Capital, details what happened when he shorted Allied Capital.

I had the opportunity to meet Einhorn a few years back, and found him to be a thoughtful fellow.
You'll probably continue to hear his name quite a bit in the near future, as he gains notoriety. He was very publicly bearish on Lehman Brothers a few months ago.

Understandably, short sellers aren't always correct. Presumably, they're wrong at least as often as they're right, just like anyone else. However, I think that it's a fallacy to think that short sellers are responsible for systemic weakness in the market.

In our current situation, can we really blame the short sellers for the ills of Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual and all of the others? These stocks cratered in response to a significant deterioration in the underlying companies' fundamentals. They made bad loans, bought toxic securities, leveraged themselves to the hilt, and shredded their balance sheets in the process. For the most part, the declines in their stock prices reflect the catastrophic value destruction in which the geniuses who run these firms engaged.

Does anyone really believe that short selling did this, or that restricting short sales will help these stocks recover over the long term?

Now, the SEC, and those who support its decison, would probably say that the intent here is simply to reduce the volatility we've seen in these stocks, and the market in general. By removing the short sellers, who can put major short-term pressure on a stock price as they're building their positions, and perhaps even greater upside price pressure on a stock when they cover, we will be able to avoid the sharp, intraday price swings we've seen this week in many of these securities.

However, there's no real long-term, empirical evidence that short selling adds volatility, or that its restriction would reduce volatility. Sure, people might look back after this 10 or 30-day short-selling ban ends, and compare the market's calculated volatility of that period with some prior period, and say that things became less volatile. Even that outcome, if it in fact occurred, wouldn't prove anything. If the market is less volatile next week, and the week after that, it's more likely the result of all of the other steps the government is taking to stabilize things, such as guaranteeing the value of money market assets.

I simply don't like a situation where only speculative buying is allowed, not speculative selling. It creates an artificial imbalance between buying and selling forces, giving the market an upward bias. Absent an improvement in fundamentals, however, this bias is sure to be short-lived. It's unfortunate that the SEC, which has seemingly been on vacation for the past several years, has fallen for one of the oldest tricks in the book.

Either way, the stock market will eventually find its own level. Hopefully, that level is higher than where we are now. I'd love to get my hands on one of those new I-Gramophones.