Opinion

Felix Salmon

The social utility of short selling

By Felix Salmon
April 6, 2010

John Hempton today lays out the short case for First Solar (and, parenthetically, Palm and Garmin as well), and in doing so says that, in this case at least, I am “not necessarily” harsh in describing such activity as “socially useless”:

If we are right (and we think we are) then we will make money from the demise of a company that has much improved the world. We like to think our business is noble. And it is sometimes – but in this case we can see why people dislike short-sellers. Their opinion however is not our business.

Even with Hempton admitting that there’s precious little social utility to his short position, however, there’s still people willing to defend him as being a force for good in the world. Aristid Breitkreuz, for instance, took to Twitter to defend the short:

Palm’s failure is totally fair. They formerly had a duopoly with Microsoft, both did not innovate at all, and now they are being crushed. Sounds fair to me. Short-selling prevents capital from flowing into these zombies which also helps socially. Capital should flow into the best technology, not the second-best. Or do you want a second-best iPad? Same for First Solar. Bill Gates did not short Kodak because he’s better at running Microsoft. John Hempton is not good at running Microsoft.

This doesn’t really stand up, I don’t think. For one thing, short selling really isn’t very good at preventing capital from flowing into companies. Insofar as it does so at all, it does so by reducing the share price, which at the margin might just make an equity investment look more attractive. And if you want to reduce the share price of a company by selling its stock, you’re going to have much more effect if you’re a long-term investor selling out of your position than if you have no position to begin with and you have to borrow your shares, thereby creating certain future demand for those shares when you have to buy them back.

What’s more, there’s good reason why capital should flow into second-best companies — not least that the best companies, like Apple, don’t need new capital at all. (Fact: Apple’s last stock issuance to outside investors was in 1981.) It’s the smaller, younger companies which need capital in order to compete with the big guys — and competition, as I’m sure Aristid would agree, is a good thing. Yes, I want Palm to come out with a second-best iPad: no good can come of Apple having a complete monopoly on such things.

And while Aristid is right that John Hempton would not be good at running Microsoft, the fact is that he’s smart enough that there is some kind of opportunity cost to his current profession, from a societal perspective. Sure, he could quit his job and become an arms dealer, and that would not make the world a better place. But equally he could quit his job and do something genuinely productive instead, and that would surely benefit society much more than he’s doing right now. In fact, Hempton’s part-time lifeguard gig is clearly better for society than his day job is.

Hempton says in his post that he “will write an article in the future on socially useful short selling”; I look forward to reading it. Here’s one question I hope he’ll answer in that article: is it possible for short selling to be useful insofar as it does not affect the stock price? If I’m a small investor shorting a large and liquid stock, is there any argument that what I’m doing can ever be socially useful? Or in order to be socially useful, does a short seller have to have a certain amount of size and firepower?

But the main reason I’ll be interested to read the article is to see how Hempton squares his argument with the much more common argument that it’s silly to blame short sellers for the collapse of Company X’s share price. It’s not easy to have it both ways — but it’ll definitely be fun to watch John try.

Comments
20 comments so far | RSS Comments RSS

don’t overthink it, Felix. If you want your markets to price assets in the best, most accurate way possible, you have to give market participants the opportunity to express their views – to sell and buy – with equal opportunity. It’s that simple.

you can take a view in favor of assets you don’t own (also known as “buying!”), so you need to be able to take a view against assets you don’t own (aka, shorting)

Posted by KidDynamite | Report as abusive
 

Felix,

Don’t the short sellers act as a signalling device telling other investors “Look more closely at your investment in this company”, and could that signalling help other investors move capital away from these losing dinosaurs into other more productive companies? For example, instead of watching your investment in Palm waste away to nothing you could look for someone else who *could* create the next iPad competitor (say, Google spinning off its Android arm into a separate business).

John’s right that short selling is in no way a judgement on a company’s *past* merits – it’s a judgement on its *future* merits, its ability to change the world *tomorrow* rather than *yesterday*, and a way to get 1980′s capital out of IBM or 1995′s capital out of Microsoft and into Google.

Posted by voodoobunny | Report as abusive
 

I have thought about this and it is an interestig question. It is true: companies go to the public markets to raise money almost never. How does shorting a company’s stock hurt it, cash-wise? Several ways I think.

If your stock price is low:
1 – You can’t raise money in the bond market easily if at all
2 – Lines of credit with your business partners evaporate as they look to be paid today, in cash
3 – Your executive and employee stock compensation schemes fall apart and cash compensation is demanded
4 – You can’t acquire anybody
5 – Other companies can acquire you cheaply

Conversely, if your stock is high, that becomes a currency to pay people and acquire companies. In addition, bond issuances will be easy.

Posted by DanHess | Report as abusive
 

KidDynamite, I agree completely. I’m all in favor of short selling, I don’t want to ban it. I just think that it carries an opportunity cost, and that it serves little if any positive social function.

 

but DanHess, Felix, the concept of “social function” is perverse. would it make everyone happier if stocks only went up? probably. why then don’t we just ban short selling completely, and ban regular selling except on upticks! it will be the icing on the cake of our perfect ponzi scheme. Markets will never go down. everyone will be happy.

my point, i think, is that accurate asset prices themselves are the social function derived from robust markets.

people may derive more social UTILITY, however, from fantasy bubble markets, which is why our entire system is incented to cater as such.

Posted by KidDynamite | Report as abusive
 

KD: “If you want your markets to price assets in the best, most accurate way possible, you have to give market participants the opportunity to express their views – to sell and buy – with equal opportunity.”

I don’t get why we need “equal opportunity” selling in financial markets, when we don’t have it anywhere else. I can’t sell apples unless I have bought them in the past or invested in an apple orchard. Does this mean that the price of apples is inaccurate? The argument seems to indicate that markets as we use them every day are dysfunctional.

Basically, the shortsellers’ argument seems to rest on the presumption that long investors are too lazy or stupid to actually monitor the companies they own. Why should I believe that?

Posted by csissoko | Report as abusive
 

csissoko – just think about futures markets. that’s the easiest example. not only can you short futures, but you “naked” short them – you don’t borrow them. Sellers and buyers meet at the proper price. it’s simple. it’s the MOST robust and efficient way.

apples are a bit different, but apple PRICES are a better analogy. I’m not sure if apple futures trade, but we know that orange juice futures do trade, so there you go… you don’t need an orange grove to sell orange juice futures. It’s just an asset price that you’re expressing a view on.

Posted by KidDynamite | Report as abusive
 

I’m with KD: it is nonsensical to say simultaneously that you are all in favor of short selling but you don’t think it has any social value. There is obvious social value in setting fair relative prices. There are already plenty of economic disincentives to shorting (it is expensive and has unlimited risk) as well as legal ones (it is outside the remit of many asset managers.) The last thing we need is some wacky socio-political restrictions.

I can’t put matters any better than timarr did in this post (http://www.psyfitec.com/2010/03/save-ou r-short-sellers.html), so I won’t try:

“Instead of banning short-selling regulators ought to be focusing on what measures they could take to make it more popular. If you want markets to be roughly efficient and not to fly off on some behaviourally induced flight of fancy then you need intelligent investors to be able to short-sell over-valued stocks.”

Posted by Greycap | Report as abusive
 

I think Felix is right. The sensible approach in the general case is to claim that short-selling is harmless — it has neither social benefits, nor costs.

Both the arguments that short-selling is bad and that is good seem to rely on very strong assumptions. There can be no argument that short-sellers improve pricing unless there is also an argument that long investors are not monitoring their holdings as well as short-sellers would. More market participants don’t lead to better pricing unless the additional participants bring better information to the market.

Posted by csissoko | Report as abusive
 

also, every seller makes the asset cheaper for the buyer. so, while I think social function is the wrong evaluator of legitimacy in financial markets, there’s your social function… if you’re a buyer, you want more sellers, including short sellers. all they do is help you buy it cheaper than you otherwise would be able to if they didn’t exist.

Posted by KidDynamite | Report as abusive
 

very interesting comment, csissoko. although i’d absolutely make the argument that long investors dont monitor their holdings as well as short sellers would, i don’t think one needs to make that argument, and it’s a tangent. i’ll get to that in a minute with your next point:

” More market participants don’t lead to better pricing unless the additional participants bring better information to the market.”

this is also very interesting. it’s beyond the scope of a comment thread, but i think people confuse more robust, efficient markets with markets that price goods “more correctly”. the two are not necessarily the same – the masses can be wrong and the market still be efficient.

and it gets back to social value. if you have an additional market participant who is “stupid,” he is providing social value (and economic value) for the intelligent market participants. One should be able to be a “stupid” short just like they can be a “stupid” long.

maybe the best way to say it is this: a market where every participant is free to express his view in an unrestricted manner is more fair (and more efficient! by definition!) than one with restrictions. I’ll leave it at that.

Posted by KidDynamite | Report as abusive
 

KD: According to economic theory, if prices do not reflect fundamentals, then we will have a problem with goods moving from the hands of people who value them more to those who value them less. This is the definition of inefficiency.

If the price of the transaction does not reflect (more or less) the fundamental value of the asset, the “stupid” market participant is providing returns for the “intelligent” participant — but these returns are not the returns of an efficient market, they are rent-seeking gains for the “intelligent” investor.

Now I’m not going to get into a discussion of fairness, but you’re not talking about market efficiency here (at least in the economic sense of the word).

Posted by csissoko | Report as abusive
 

csissoko, you subscribe to a far stronger version of EMH than I would care to endorse. In my experience, only a small minority of long investors are “monitoring their holdings” in the sense of forming an independent opinion of value. On the other hand, practically all short-sellers are doing so. That is not merely or even mostly because they are professional investors, but because they are running much greater risks.

A substantial body of long investors derive their primary information about value from prices and changes in prices. When this body is large enough, that view is self-reinforcing. When short-selling is not available to restore reason, the critical mass at which runaway occurs is smaller. Perhaps that contradicts the version of economic theory you favor, but it is the way bubbles form in the real world. If economic efficiency is a social good, it follows that short-selling is not just harmless but rather beneficial.

Put it this way: if you accept the proposal that investment bankers are overpaid, and that this excess compensation has attracted talent at the margin that would otherwise have been deployed to better purpose, would it not have been a social good to have been able to set “correct” compensation levels? Unfortunately, IB’s are not traded assets …

Posted by Greycap | Report as abusive
 

prices reflect the markets net ASSESSMENT of fundamentals. that’s what an efficient market is. it’s kinda like one big cross-product of each participant’s capital and viewpoint. if you remove some of the participants from that equation, it’s less efficient.

i’m not sure why you make it sound like rent-seeking and efficient markets are mutually exclusive. they go hand in hand. the smart capitalize on inefficiencies created by the less smart. that is exactly how markets work. you can call it rent seeking – i call it simply: MARKETS.

but anyway… have a good night.

Posted by KidDynamite | Report as abusive
 

Greycap: I don’t think we disagree. You are arguing that short selling adds informational value to the market, which is precisely the argument that I think needs to be made in order for short-selling to be beneficial. You may well be right. I don’t have the knowledge to confirm this independently however.

I don’t espouse the EMH (Efficient Markets Hypothesis), but it is the source of the definition of market efficiency. I would not argue that real world markets are either efficient or fair. But they may, when carefully regulated, be the best substitute for efficiency and fairness that we have.

Posted by csissoko | Report as abusive
 

Perhaps a dumb observation:
If we are talking about a stock that is going to zero, then the socially useful function of the short-seller is to lower the overall value lost to investors.
Without shorts, the entire market cap would be lost.
With say, 10% of the shares out sold short then that value has been saved since that is exactly how much the short sellers made.

Taking that ad absurdum we should have 100% shares out short and the investment community would never lose money!!
Of course, they would never make it either.

If you want to ban short selling then you should ban selling too. They are one and the same thing, except for slightly different starting points.

Posted by TinyTim1 | Report as abusive
 

If DanHess is correct about the affects of stock prices on companies, then clearly having an accurate price is socially useful; a stock price higher than deserved sends an inaccurate signal to the companies’ counterparties for each of those transactions.

If that’s the case, then the social utility of shorting depends on whether it is more or less likely to produce accurate values of stocks, as well as how damaging the inaccuracies are in each case. I could see an argument that shorting leads to generally more accurate prices, but the times that they are inaccurate are more harmful than the benefit from when they are more accurate.

I think I need to read the argument against short sellers more fully fleshed out.

Posted by MattJ | Report as abusive
 

I’m not a follower of Austrian economics, and I don’t agree with Maggie Thatcher’s statement that there is no such thing as society. That said, I think individualism in investing should the ordinary starting point for stack market analysis, and any argument premised on “social utility” is suspect. What’s good about short selling at the individual level is that a short sale today is a promise of purchase tomorrow, and a short squeeze is a great place for a bull rally to start. It puts liquidity in the market. It’s only in the rare situation where essentially all buy side liquidity dries up that short selling seems problematic, but even here it is the short himself who has to arrest the fall by stepping in and covering. Efficient or not, markets need real forces to achieve reasonable prices and shorts are an effective force in this regard. Thought pieces at the 40,000 foot level of social utility are interesting reading, but policymakers should stay well away.

Posted by tk5656 | Report as abusive
 

For the record, it is plain to me that short sellers serve a critical role, because if a price is either too high or too low, capital is be misallocated. My earlier comment should make clear that stock price translates to availability of capital. There are many more mechanisms for translation.

If a stock price is too high, a company is able to get its hands on more capital than it can effectively use and capital is likely to be wasted or destroyed by returns that are too low or actually negative. If a stock price is too low, capital is not flowing to a place where it would be put to good use and have a good return.

Posted by DanHess | Report as abusive
 

Socially useful reasons to sell short:

- The short sellers in bear markets or corrections are stabilizing forces, in that they step in and buy when stocks go down to cover their shorts.

- To uncover frauds; many times short sellers identify bad accounting or management teams that are doing wrong.

- To hedge positions for investors in the funds and generate higher risk-adjusted returns.

Posted by BenG | Report as abusive
 

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