Three cheers for short-sellers

By Felix Salmon
August 7, 2009
Xiaoxia Lou and Jonathan Karpoff, somewhere between 0.2% and 1.5% of the firm's market cap.

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What happens when companies engage in fraudulent activity? Short-sellers get wind of it, and, by selling the stock of the company in question, depress the share price and save uninformed investors some of the loss they would otherwise have suffered had they bought in at an undepressed level. How much is that worth? According to Xiaoxia Lou and Jonathan Karpoff, somewhere between 0.2% and 1.5% of the firm’s market cap.

But what if the short sellers have it wrong, and the company in question is not engaged in fraud? Well, in that case the uninformed investors have just been given the opportunity to buy into that question at a discount, thanks to the shorts. They win again!

Is there any downside to short-selling? Not really: the authors say that “there is no evidence that short selling exacerbates a downward price spiral when the misconduct is publicly revealed”.

So thank you, short-sellers, for saving us from buying in to fraudulent firms at inflated prices, and from giving us a nice discount on the share price of non-fraudulent firms. You rock!

(HT: Marr)


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buy one, sell two

Posted by dvictr | Report as abusive

The other side of the coin is, of course, that honest companies mistakenly shorted have to pay a premium to access capital markets, because their shares are trading lower than their intrinsic value. Current uninformed shareholders are punished. This does not enhance welfare.

In the same vein, one could say that momentum investors pushing up the price of growth companies are an unalloyed good: they either allow good companies to raise more money, or, in the case a non-growing company is mistakenly promoted, of allowing current uninformed shareholders to sell at elevated levels.

(now that I think of it, that was probably the exact reasoning of investment bankers during the dot-com bubble)

In conclusion, it is never good when the short (long) side pushes a company down (up) on anything but its merits; uninformed investors and current shareholders are punished either way and total welfare is reduced.

Genuine growth companies and genuine frauds, evidently, deserve recognition.

Posted by Hans | Report as abusive

Hey, this is great. Free money. It doesn’t matter whether the short-sellers are right or wrong, we make free money because of what they do. Clearly, this is how we can pay for health care reform. The government can buy stocks and bonds and then hire some short-sellers to target those issues that the government is interested in. Free money, just like perpetual motion machines provide free energy.

Posted by hedberg | Report as abusive

hedberg nailed it, the perpetual motion machine. that analogy aptly describes so many “financial engineering innovations”.

Short selling adds downward pressure on any stock, because it artificially inflates the number of shares for sale. The more shares that are available to purchase, the lower the price for those who want to purchase the shorted stock. How is that fair to the company whose stock is being shorted?

If all you care about is volatility, then there are lots of ways we can increase it without resorting to misinformed short sellers. Let’s get rid of restrictions on insider trading and spreading rumors about publicly traded stocks. Lots of people will make money, lots will lose, but more importantly, the brokerage firms will make money on the increased trading levels.

Posted by KenG | Report as abusive

It had long been my understanding that short-selling required that actual shares be “borrowed” in order for the short sale to occur. This could result in a margin call if some other claim occurred against the shares that had been sold short. But, within the last several years I have heard about regulators clamping down on “naked” short-sellers who somehow were able to sell shares that didn’t actually exist. At least, that’s my impression of what naked short-selling is. It seems to me that, whatever the effects of traditional short-selling, allowing people to sell shares that don’t exist has the ability to cause some significant negative externalities.

One other point about short-selling: it creates a demand for shares to be purchased to satisfy the borrowing. In other words, sooner or later, the short sellers are going to have to buy the stock. That’s why a large short position is sometimes considered a bullish indicator.

Posted by hedberg | Report as abusive

This post makes no sense. Stock trading is basically zero-sum so the profits informed traders (whether short-sellers or insiders) make are at the expense of uninformed traders. Note if short-selling decreases the price each uninformed buyer will lose less but there will be more of them as naive buyers are attracted by the apparent bargain.

Short-selling can be justified as helping keep markets honest but it is not a benevolent activity.

You say if the short sellers have it “wrong”, the mispricing is still a benefit to uninformed investors. But investors are necessarily buyers and sellers both at one time or another, so what of the equal loss to uninformed investors who happen to decide this is the time they must trade out of the position? Second, do you not believe that markets and their price discovery role help society allocate capital well? If so, surely a “bad” price must have some adverse consequences with respect to this goal.

However, I just cannot find anywhere in the paper that talks about the “getting it wrong” case – can you maybe pinpoint the section you believe supports your view here? Or says anything at all about this case? Or perhaps this part of your analysis is your own contribution; if so I sincerely recommend you give it a bit more critical thought.

In general, this paper is talking about the effect of short sellers on and around the actual revelation of accounting fraud, and finds it weakly positive (in some respects, though not overwhelmingly so) *in this case*. This is very plausible and I suspect even some firm opponents of short sales might concede as much: here we are conditioning on the fact where there IS something seriously wrong (but not yet publicly known) about some company, and short selling provides an incentive for people to investigate and discover the problems (or – more questionably – act on insider information). It’s not a shock to find external benefits to short selling GIVEN the short sellers turn out to be right and company turns out to actually up to no good!

The authors’ introduction clearly say “these findings do not address whether short selling _in general_ is informed and beneficial” and so far as I can see they remain disciplined in restricting their conclusions just to the particular scenario under investigation. IMO you are stretching their results fallaciously far.

Posted by axg | Report as abusive

This is a joke, right?

Posted by carping demon | Report as abusive

I only count 2 cheers

Posted by jacobson | Report as abusive

I love short sellers!
I love short squeezes.

WOOT WOOT! lets here it for shorters!
Both cheaper stocks when they are correct and nice price rises when they are incorrect!
Shorters are a long speculator (LIKE ME!)’s best friend!

Posted by Doc Merlin | Report as abusive

Nice post – one of your very best.

Posted by Sunset Shazz | Report as abusive

Obviously short sellers are only a positive force when they are correct in ferreting out companies that are not worthy of their market capitalizations.

When short sellers are wrong, they pull capital away from a company that should have it.

Thankfully there is a beautiful mechanism in the market to smite short sellers who are unjustified in their shorting activities, the squeeze! If major investors or the company itself understands that a collapsing stock price is not right, they can start buying up shares, or hold fast to the ones they have and watch the shorts get set aflame.

Posted by Dan | Report as abusive

GOOD NEWS!!! There is finally great new movie out about market manipulation, the SEC, and short selling called: “Stock Shock.” For those of us that want to understand some of the inner workings of the market, it is a must-see. Very easy to understand and entertaining. Amazon has it or has a trailer.