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Short-selling and tall ponies

Scott Jagow Apr 6, 2009

The short-selling of stocks will get a lot of attention this week. Wednesday, the SEC plans to make several recommendations for restricting short-selling. Selling short means borrowing stock and then selling it with the notion that its price will go down. If it does, you make money by buying it at the lower price and repaying your loan.

Some people believe short-selling should be banned altogether because it encourages value-destruction and has the potential for making a bad stock market worse. Blogger Sramana Mirtra lays out that argument:

One of the problems that we have with Wall Street compensation is that traders make money both as the market goes up and as the market goes down. And often, a tremendous amount of market manipulation is going on in the process, destroying many people’s honest, hard work…

No one should be making money if a company’s stock is going down. And especially, no one should have the incentive or the tools to bring a company’s stock price down.

On the other hand, you have people who say short-sellers are the market’s “whistle-blowers.” They do their homework, and if they see that investors are piling on (herd mentality) to a particular stock, they make their move. From John Tamny, an economist with Real Clear Markets:

Short-sellers provide information, or what some call “feedback,” to investors. When their activities are made illegal, information that is necessary to correctly price securities is lost. When that’s the case, investors with long-term objectives frequently disappear because of their inability to buy shares that are correctly priced. This explains why the ban (on short-selling) in the ’30s led to market sell-offs that were more extreme.

I think both sides have a good argument. There’s something to be said for simplifying the market to buying and selling stock that you own. Things have gotten so complicated — bets on bets, insurance on bets, insurance on bets on bets, borrowing to make bets on bets. It’s a casino, so enter at your own peril.

I also see the value in short-sellers. People criticize them for piling on a weakened stock and driving it down further. But what about the buyers who drove it up beyond all reason? There’s plenty of stock price manipulation to the upside, too. Shouldn’t somebody call them on that? And I don’t mean analysts or credit-rating agencies. Somebody with skin in the game.

I don’t do short-selling, but to continue the gambling analogy, I do love horse racing. It’s the only gambling I do and here’s why — because the betting is parimutuel, which means among the bettors. There is no “house” that dictates the odds. If you do your homework and outsmart the other bettors, you win. It happened to me on Saturday at Santa Anita. I looked at the board and saw a horse the public was pricing at 13-1. Based on my homework, I thought, no way that horse should be any higher than 7 to 1. The bettors were piling on another horse and made him 2-1. My opinion was that he didn’t deserve 2-1. So I put my money on the 13-1, and he came in first. I made a nice profit for outsmarting the crowd. That’s the way a market should work.

Of course, I didn’t borrow the money to play and would never advocate short-selling unless you have the cash on hand. And “naked” short-selling, where you don’t even have to borrow the shares, should be and is illegal. Still, people complain the SEC doesn’t enforce the rule, and that’s the problem I have with restricting short-selling. I can’t imagine the rules will be effectively enforced based on the SEC’s “track” record.

Either simplify the stock market entirely, or let short-sellers do what they do.

(Pioneer of the Nile was effectively priced by the bettors. He won the Santa Anita Derby at 1-1.)

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