What use short selling?

By Felix Salmon
December 30, 2009
the dangers of shorting frauds, and now he's writing about the dangers of shorting an industry in terminal decline. At least he's not doing this kind of thing at book length: David Einhorn spent 380 pages detailing the dangers of shorting Allied Capital.

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I’m noticing a theme chez John Hempton: a few weeks ago he was writing about the dangers of shorting frauds, and now he’s writing about the dangers of shorting an industry in terminal decline. At least he’s not doing this kind of thing at book length: David Einhorn spent 380 pages detailing the dangers of shorting Allied Capital.

The general idea here is that no matter how perspicacious and intelligent a short seller is, he can still be entirely correct and lose lots of money. As Hempton writes today:

If you understood the implications of digital photography in 1991 you were – at least on that item – the smartest guy in almost any room. And it did not help you make (much) money.

Well, yes. And, good. Hempton’s talking about an episode where Warren Buffett was talking to Bill Gates in 1991, and Gates said that Kodak was toast. Neither Buffett nor Gates thought that, even if Kodak was toast, they should go out and short the stock. But because Hempton’s a short seller, that was the first idea that sprang to mind.

Bill Gates, of course, had much better things to do in 1991 than short Kodak: he was using his intelligence and perspicacity to build Microsoft into a global giant which has fundamentally changed the lives of billions of people. Short sellers, by contrast, are what Adair Turner would call socially useless.

Let’s say I’m an intelligent and perspicacious short-seller who correctly believes that Kodak shares are going to fall. Kodak has shares in the first place, remember, because it needed to raise equity capital to build a global company capable of changing the world in fundamental ways. A large number of long-term investors then bought those shares, becoming part-owners of a then-successful real-world company. I then approach one of those large, long-term investors, and ask them to lend me their shares for a short while. I’ll pay them a modest interest rate for the privilege, and they’ll end up with just as many shares as they started with, so they agree.

The next thing I do is to immediately sell those shares on the open market, to someone else who believes in the future of Kodak. I then sit back and wait, as Kodak shares fall in price. Eventually, I buy them back cheap, return them to the original long-term investor, and pocket my profits.

Now I don’t think that this exercise is particularly harmful on a societal level, and at the margin it can help to make markets more liquid and efficient. But I can’t help but think of the opportunity cost of having all these intelligent and perspicacious people playing around on stock markets, rather than going out and putting that intelligence and perspicacity to more socially-beneficial use.

It’s not just short-sellers, either: most financial professionals are essentially parasitical on people who genuinely add value in the real world. Old-fashioned lending is important, and I’d say that stock markets in general also count as a positive financial innovation, since they make it vastly easier for companies to raise equity capital. But in my ideal world, people working for real companies like Kodak would make more money, in general, than people working for more parasitical financial-services companies. The fact that it’s the other way around worries me. While finance may or may not be good at the efficient allocation of capital, it seems to be positively bad when it comes to the efficient allocation of the labor of intelligent and perspicacious individuals.


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I like what you say. But arbitrage is an abyss.

Posted by rbrowne | Report as abusive

I’m glad you admit this: short sellers are parasites. They add no value to society, and artificially inflate the number of shares of a stock that are available for purchase, which makes them cheaper. Anybody who lends shares to a short seller is either overly confident or the guy selling rope to his executioner.

Short selling does not make markets more liquid or more efficient. It is just a form of gambling that distorts market valuations.

Posted by OnTheTimes | Report as abusive

The reason that people at world changing companies will continue to be paid less is that to build a world-changing company you need capital, that has to be compensated in form of interest and dividends.
Finance is a pure return on capital game, you need an office some workstations and you are in business. Inherently there is little deadweight loss in finance and hence after copensating capital via ‘AAA’ rated bonds the rest is left for the workers whether they be MDs/partners with equity in company or first year traders.
There is another industry which functions similarly and that is the software products industry. The reason compensation does not go haywire here is that the people doing the heavy lifting, the programmers need to work in teams and however good an individual programmer may be he or she cannot make or break the bank unlike a trader.

Posted by Anonymous | Report as abusive

To go long a stock is to short the dollar whereas to short a stock is to go long the dollar. So which investors are NOT shorting?

Posted by realhoot | Report as abusive

if, as you say, “most financial professionals are essentially parasitical on people who genuinely add value in the real world,” what does that make financial bloggers?

Posted by JoeP | Report as abusive

“what does that make financial bloggers?”

Or commenters on financial blogs? There’s no end!

Posted by Uncle_Billy | Report as abusive

I don’t short. Short selling is socially productive though. Here is how:

1) Sniffs out bad management teams.

2) Sniffs out bad accounting.

3) Adds liquidity.

4) Defrays the costs of the margin account for retail investors. Institutional longs get a rebate. Securities lending programs provide real money to long term investors, with additional fun because when you want to sell, you can move the securities to the cash account if the borrow is tight, have a short squeeze, and sell even higher.

5) Provides useful data for longs who don’t short. (High short interest ratio is a yellow flag in the long run, leaving aside short squeeze games.)

6) Allows for paired trades.

7) Useful in deal arbitrage for those who want to take and eliminate risk.

8) Other market neutral trading is enabled.

9) Lowers implied volatility on put options. (and call options)

10) And more, see: http://alephblog.com/2008/09/19/governme nt-policy-created-too-hastily/

Short selling is a good thing, and useful to society, as long as a hard locate is enforced.

Posted by DavidMerkel | Report as abusive

What if you don’t assume with hindsight that Kodak was pre-ordained to fail. What if intelligent short-sellers educated the market about Kodak’s futures in time for management to get the message and fix the problem (market leading innovation in digital, deep research and strong patent protection, etc.) Maybe Kodak would be stronger today.

Gates had the information and shared it with just a few people. That did no good for the management and shareholders of Kodak. Short sellers would have the profit motivation to do a better job.

Posted by Steve65 | Report as abusive

Kodak buyers at the peak lost 95% of their investment. Short sellers could have performed a socially useful function by preventing Kodak from ever getting to $95 by continuing to provide selling liquidity and educating the market about Kodak’s future.

Reducing volatility like this would reduce the lottery-like nature of the market where the difference between haves and have-nots is largely a matter of luck. And that would be socially useful.

Posted by Steve65 | Report as abusive

Steve55 puts it very well. Short-selling helps keep a lid on speculative excess. Short sellers prevent too much speculative capital from entering the market, and from being allocated inefficiently.

The function of the capital markets is simple, to allocate capital to those firms most deserving of it.

The problem is in how that determination is made. Without short sellers you would have a market more like that of housing. One that functions in only one direction. That is not in society’s best interests. For evidence, see the housing market of recent years.

Perhaps the larger issue is that short-sellers have taken on the tasks that the regulators and journalists believe belong to them. Even more embarassing for the government and 4th estate is that short sellers consistently ferret out frauds and bubbles far quicker, more effectively, and (gasp) for a healthy profit.

Professional jealousy Felix?

Posted by Anonymous | Report as abusive

please do not generalize.

i short sell. i also donate over 90% of my after-tax gains (i am onshore and do not dodge the tax man) to a number of social causes that i think are important.

i could be mistaken but the medical researchers that i support in the uk do not think that i am socially useless. these folks are brilliant but find it almost impossible to receive funding from the established channels – so i help them. i am also thrilled to know that their work will be published in the next 12-18 months (depending on the turnaround of several journals) which will make headline news.

my wife is a school teacher and is working on a number of education programmes that my short-selling funds. i am happy to get into details but the basic point is the same – the governments, NGOs and private donors who we reached out to for help wanted to play politics instead so rather than ensuring red-tape, we, as a family, are trying to be social entrepreneurs. the kids in the indian village where my grandmother grew up seem to be over the moon. again, i could be wrong, but i do not think that they would brand me socially useless.

i am not smart enough (i wish i were) to cure cancer, capture carbon or to figure out how to fund the west’s entitlements but i do have a good sense when management teams are lying to me and when markets get ahead of themselves. so sure, my direct day-to-day, does not improve the world – i cannot accept that but please do not generalize. some people try to do some good with their profits. i can also give you the libertarian treatise but we can debate ideology forever. my simple point is that short selling is not a pure end in itself and sometimes can lead to some good.

please do not generalize. i short sell but do so in order not to be socially useless. being long in 2008 cost alot of people their retirements and good causes their endowments. now are those financial advisers or fund managers socially useful?

Posted by lsa2010 | Report as abusive

Isn’t the whole point that the people working for Kodak have *not* been “genuinely add[ing] value in the real world” but instead wasting their efforts for the last 2 decades? Short-sellers have helped reduce the degree to which that is true.

Would it be better if short-sellers instead went and built another film company?

Posted by fmb21 | Report as abusive

> While finance may or may not be good at the efficient allocation of capital, it seems to be positively bad when it comes to the efficient allocation of the labor of intelligent and perspicacious individuals.

On many levels, I don’t get this. At the most immediate level, doing quality, in-depth analysis of companies — whether your bias is long or short — requires intelligence and perspicaciousness, so some degree of allocation of talent to finance is always going to be useful and beneficial.

Bigger picture, you may well think there are too many people playing the finance game today, and I wouldn’t necessarily disagree. But the extent to which finance has drawn talent away from less “parasitical” industries is a direct function of the obscene profits to be had in finance in recent decades, which in turn is derived from the outsized share of the gains corporations (and their owners, in the form of shareholders) have received from business activity (arguably at the expense of workers). If you think this is a societal ill, then the obvious policy solution is to reduce corporate profits as a share of GDP, and thus diminish the opportunity for parasitic profit.

Posted by MarkC123 | Report as abusive

This is an old theme. Felix does not say that *finance* is useless in general, and that charging interest is *contra naturam* (or at best “socially useless”), but he gives no argument against short selling and (unspecified) other financial activities that would not apply equally to lending at interest.

Posted by Philon | Report as abusive

‘social productivity’- another well intentioned, scientifically dubious journalistic slap at financial markets by a man who should know better. You either allow free markets to allocate resources or you leave it to grand Soviets and government ministries. To say that short sellers are wasting their talent by playing a part in the aggregated resource allocation mechanism of society is to say we should all start queuing for the bread line.

Socially unproductive work is a reality of a world of human self-interest. Even in your populist dream world where bankers till the fields and traders run charity bake sales for the poor, smart people would still spend plenty of time ‘gaming’ systems and markets for their own advantage. Whether that takes the form of short-selling, learning how to card count in blackjack, practicing the SATs, or figuring out how to legally shield the most of their income from the taxman.

Mindless drivel.

Posted by bleichroeder | Report as abusive