Pay heed to short sellers
As doomsayers from Nostradamus to Cassandra have learned to their great distress, nobody likes a spoilsport.
That seems to be the guiding principle behind the perennial complaining on Wall Street and Main Street about the practice of “short selling.”
The prevailing opinion can be summed up as this: Nasty creatures, those short sellers -- always looking at the dark side, raining on every parade. Gangs of corporate chief executives regularly march on Washington to demand that somebody do something about short sellers (typically when the stock market turns down). The next thing you know, the Securities and Exchange Commission is holding a meeting about the subject.
Like it did Wednesday.
The SEC’s new chairwoman, Mary Schapiro, kicked off Wednesday’s meeting by observing that in her roughly 10 weeks in office, short selling has generated “more letters from investors, brokerage firms and exchanges, more inquiries from members of Congress and more questions from reporters than any other topic.”
She has my sympathy. Considering that this period has encompassed such lively controversies as bank accounting irregularities, the AIG revelations and the Bernie Madoff scam, you’d think people would have better things to write letters about. But the idea that short selling is a uniquely nefarious practice never seems to go away.
Wednesday’s meeting closed with a unanimous vote to put a roster of anti-short-selling measures out for 60 days of public comment. If you listened in, as I did, it sounded as if the commission wasn’t sure it wanted to do anything, but felt obliged to put the issue out for discussion.
One cause of the persistent outcry about short selling is public ignorance of just what the practice entails. So here’s a primer: In its basic form, it’s selling stock that you don’t own but have borrowed, with the idea of buying it back later at a lower price and pocketing the difference.
Think of it as running the investment principle “buy low, sell high” in reverse -- you sell high first, then buy low.
Plainly this is a rational strategy if you believe, or fear, that a stock’s price is headed down. It is not illegal, and in some places, like futures markets, it’s positively welcomed. But it goes against the grain: Selling something you don’t own smacks, at first blush, of a confidence scheme.
Plus, the very idea of someone acting on a cynical hunch undermines the sunny optimism that Wall Street brokers and corporate bigwigs love to peddle to the public.
“The problem is that short selling is viewed as un-American,” USC finance professor Lawrence Harris, a former SEC chief economist, told me. “But it’s very important.”
That’s because unalloyed optimism is unhealthy for capitalism, as living on a diet exclusively of Twinkies would be for you or me. Almost every participant in the system wants to see markets rise, so the general impulse is to suppress bad news and play up, or even make up, good news.
Short sellers provide a necessary corrective to this tendency. Shorts sounded early alarms about Enron, WorldCom, American International Group and failing investment banks, albeit generally to a blinkered and willfully deaf investment world.
Consider the experience of Jim Chanos, an outspoken short who turned his cynic’s eye in 2000 (not for nothing is his investment firm named Kynikos Associates) to Enron’s financial statements. There he discovered all sorts of shenanigans hiding in plain sight.
As Chanos told Congress after Enron’s collapse, he checked with several Wall Street analysts who were following the company, only to be struck by how many “conceded that there was no way to analyze Enron, but that investing in Enron was instead a ‘trust me’ story.”
Chanos fattened up his short position in the company, presumably reaping a windfall when it fulfilled its destiny by going under in 2001.
Obviously, it’s more convenient for a CEO to bellyache about short sellers ganging up on his stock than to confess that he’s run his company incompetently or dishonestly. Yet executives invariably get a sympathetic hearing from Congress and regulators.
Just last week, six U.S. senators hectored the SEC to do something about “abusive short selling” and “manipulative short selling” which, they said, “simply must end.”
This despite the absence of any evidence that short sellers manipulated stocks in any of the truly spectacular flameouts of recent months. Bear Stearns, Merrill Lynch and Lehman Bros. were all firebombed by their own managements with no help from the outside, thank you very much.
On the other hand, there’s evidence that the regulations now under consideration by the SEC will be useless or unfair, or both.
One idea, for example, is to restore the “uptick rule.” Eliminated in 2007, this Depression-era rule prohibited executing a short sale on a stock unless the prior trade was at or above the previous price. The idea was to hamper “bear raids,” in which a cascade of short sales relentlessly pressures a stock lower.
In today’s markets, where price changes can be as small as a penny, an uptick rule might delay a price decline by “maybe one minute,” says Pete Kyle, a markets expert at the University of Maryland. In other words, it’s no panacea.
Indeed, the SEC’s last big anti-short initiative was a bust. That was the ban on shorting nearly 1,000 financial stocks the agency imposed from Sept. 19 through Oct. 8 last year, when there was widespread panic about shorts supposedly gearing up to trash the entire high-finance industry, one Wall Street icon after another.
In the long term the move utterly failed to stop a fundamental (and justified) revaluing of financial stocks. But it may have temporarily pumped some stocks higher than they should have been, only to fall back to Earth later -- to investors’ misfortune, USC’s Harris says.
“Those who bought during the ban overpaid,” he says.
Perhaps more damaging to investor confidence, Chanos says, the ban “just showed the government was willing to enact abrupt financial market rule changes in response to pressure from the banking and brokerage industries.”
What’s really needed in the stock market is more and better information, which is what vigilant shorts provide. The wise investor gains not by driving them away but by listening to what they say.
Let’s not forget that when the god Apollo decided to punish the seeress Cassandra for spurning his love, his curse wasn’t that her predictions would be wrong, but that they’d be disbelieved.
Michael Hiltzik’s column appears Mondays and Thursdays. Reach him at email@example.com and read his previous columns at www.latimes.com/hiltzik.