one perspective on shorting and the uptick rule debate
I am making a blog out of my thoughts on short selling and the arguments that proponents of short-selling (almost inevitably people who trade or like to short) make against the uptick rule and in favor of shorting. This blog is not meant to debate that shorting should be allowed (although, frnakly, if you want to you can go short via the options market by buying a put and selling a call at the same strike price, this is called a "synthetic short" and has the same effect in most cases).
I should also disclose that I have made a nice profit in real life... by borrowing shares of levered ETFs (bear ones, maybe some profit on the bull ETF shorts I have out right now) and shorting them. The old "red thumb" to levered ETFs here on CAPs works in the real world too.
Proponents of short-selling like to mention that "bull-raids" or "pump-and-dumps" are more common and more commonly successful than "bear raids" or "short attacks". And I don't dispute that or doubt that it is true.
I am not, in making this note, saying that pump and dump isn't a problem (it is, remember the ARNA situation a while back when that hyped up email went out everywhere, i got like 10 copies, the price rallied only to crash again). And pump and dump is probably a significant part of how "pros" transfer money to them from "individuals". I do not deny manipulation on the long side and I don't dispute everydayinvestor's insinuation that this is more common than short side manipulation.
But it is worth mentioning several points:
A) pump and dump cannot cause permanent harm to a company or its shareholders. in the fullness of time the shares will be worth what they will be worth and will gravitate towards something resembling fair value. if they baloon over that for a time, ... no actual permanent harm is done to the whole, although significant harm may befall the few who buy the irrational top.
B) short selling can cause permanent harm to shareholders and a company. Take a case like what may hav ehappened to MGM earlier this year. The shares hit $14, the announced a secondary, the shareddropped dramatically in hours, and the secondary wound up being priced at $7. The net result of this is that MGM shareholders were diluted mor ethan would have been necessary, a permanent harm. Also the company loses some incremental ability to raise equity in the future via this dilution, a permanent harm. Was that the result of a bear raid, a short attack? I haven't any clue, but if a company announced a secondary and I was short I'd be real interested in knocking the offering price down for the reasons above.
Similarly, companies like REITs and BDCs which rely on share issuance for basic operations and growth. The model is to issue shares, invest the proceeds from the share offerings, then turn around and distribute the profits from those investments to shareholders. An assault on a BDC - which have hardly been infrequent from what I gather over the years - risks permanent damage to the business model and with it permanent damage to the small businesses that it services.
Pump and dump does not create a potential for permanent harm to a whole of an organization, its risk is limited to permanent harm to the "suckers" that bought into the pump.
That is a fundamental and sweeping difference that should not be ignored.
C) rising stock markets create wealth and in more ways than just the on paper marmket cap of the NYSE. They instill confidence, they empower companies to invest (as with share prices at reasonable levels they have reasonable means of raising capital should need be), they empower consumers and others to spend and invest, they create the opposite, to an extent, of a Keynesian downward spiarl. A crashing market, on the ohter hand, creates a distinct loss of confidence at both business and consumer levels, reduction of investment and reduction of everything good.
It is fundamentally better for a society to have its markets higher. And stable. Bubbles are wildly bad (more on that later). (more on bubbles and stability later). For nonw I will leave this point to stand uncontested in my commentary: an S&P at 1060 is better for the economy, country, and world than an S&P at 800.
D) naked short selling is absolutely preposterous. you have, literally, in naked shorting a stock diluted it and reduced its value by increasing the float. You've created shares that don't actually exist (same effect as dilution, net effect is to at least unti you cover, provided naked shorts do always cover, you have actually lowered the value of each share). Any argument to this is folly, in my view. Naked shorting is severely not good.
These are my core points: a pump and dump cannot harm a company or permanently harm shareholders en summe, shorting can (as explained above).
I will nown take a look at a couple potential arguments in favor of shorting, arguments that presume that shorting offers advantages to the market.
1) shorting could work to prevent bubbles. Savvy short sellers could see prices rising unreasonably high, and short them, and in doing so work to prevent a bubble. This would prevent the greusome aftermath that bubbles can leave.
And indeed the aftermath of a bubble can be greusome. The loss of wealth in the nasdaq bubble crash probably plays a role in where we are at today, that was probably the first catalyst. The loss of wealth and systemic problems caused by the housing bubble are well known.
But lets face it, short selling didn't prevent the Nasdaq bubble from occuring. And short selling didn't prevent the bubbles around 2007 in Casino, REIT, BDC and private equity stocks and more, did it? Did it prevent teh great commodity bubble of 2008? nope. Could the ability to short-sell housing prices have prevented the housing bubble? Why on earth would we believe that when it doesn't appear to have prevented any other bubbles throughout history?
Indeed, basic psychology and market dynamics and the tendency of traders to follow momentum create a situation that in rising markets (that may create bubbles) people are very shy about shorting. They are aggressive about shorting as the market crashes. This tendency to short a tumbling market excacerbates volatility, it doesn't mitigate it. Record short levels at the march bottoms, they have been falling ever since.
2. Short sellers provide needed liquidity. What % of liquitity is provided by short sellers? is it even remotely significant? If so, fine, but I doubt that it is except during epic crashes.
3. it helps price discovery. BS, see my comments on it preventing bubbles above, it exacerbates errors in pricing on the downside and does little to prevent excessive pricing on the upside.
Now, moving on to my last point and one I'll label with a roman numberal, I, ...
I) volatility in markets works against the greater good. The good part of the capital markets and commodity markets and so forth is that they provide capital for investment, which in turn provides employment, and also provide a way for people to invest in economic growth (and they are very efficient at doing this over long periods of time).
But in times of irrational upward volatility (the pump and dump) money is transferred from many to few (the many who jump on the train to the few standing there to short it when the party ends or sell before the top).
In times of irrational downward movement, the same thing happens (in theory, feel free to debate these two points). Panicked investors sell out and lose permanent money by missing the wave up.
These points are perhaps only modestly made above. It has been discussed here and eslewhere that a fundamental flaw of the markets is that the facilitate the transfer of wealth from the many (where it tends to be productive) to the few (where it tends to be hoarded), this is fundamentally harmful to the greater good of a society because great welath is attained WITHOUT ANY PRODUCTION, and money is moved from productive persons to non productive persons.
Some of this will always occur, it cannot be avoided. But epic sweeping scary volatility (bubbles and crashes and bubbles, oh my!) enhance the magnitude of this transfer and that is a very bad thing.
Frankly, I think restrictions on short selling would help reduce volatility and, frankly, I think that the elmination of the ability to use big margined positions would also help (and help mitigate "bull raids" or "pump and dump" scenarios, perhaps). A minimum holding period could be considered.
Volatility works to reduce the value of the capital markets and transfer wealth from productive areas of society to non productive areas of society.
Uptick rules and margin limitations and many other things may well work to reduce volatility and improve society. Funds should be limited in size, any measure that could be taken to reduce volatility (both bull bubbles and bear bubbles) to a normal healthy level from the manic insanity of the last 10 years IS A VERY GOOD THING FOR THE GREATER GOOD.
In sum, short selling does carry actual fundamental risk and can cause permanent harm to companies and individuals in addition to a sort of transfer-of-wealth-effect from peopel nerviously selling out as prices drop. Pump and dumpcan only cause the transfer-of-wealth damage and is not as great a potential evil as short manipulation. A bull raid cannot cause as much harm as a bear raid.
here endeth the commentary.
reinstate the uptick rule. People who are in the "transfer" business -vs- the "investing" business like it, people who want to see a market crash like it, so its gotta be undesirable. and while you're at it consider some of the other limitations and restrictions I suggest above. While (everydayinvestor in ibvalueinvestings blog today) people have argued that the uptick rule isn't effective, that is not a viable argument against it.