There's Nothing Wrong with Short SellingTags Cronyism and CorporatismFinancial Markets
The recent GameStop short-squeeze drama has riveted financial markets. Given the historic unpopularity of short sellers (e.g., Holman Jenkins has written that “short-selling is…widely unpopular with everyone who has a stake in seeing stock prices go up”), the resulting heightened invective against them is not a surprise.
Unfortunately, an intensification of this rhetoric could lead to unwarranted broader restrictions on short selling, indicated by the politicians already calling for hearings that could be used to do just that. It would hardly be the first such abuse. For instance, when Joe Biden became vice president, he was replaced in the Senate by Edward Kaufman, whose first legislative initiative, after “a lobbying campaign by financial institutions and other companies, which have experienced sharp declines in their stock prices, and their allies in Congress,” would have restricted short sales, according to the New York Times.
That danger requires us to think more carefully about short selling than most have seemed willing to do.
To see to the core of the issue, we must recognize the bias from the self-interest of current stockholders, firm managers, stock exchanges, and a host of others who have an interest in higher prices for the assets they own, not to mention regulators whose oversight role has often been better performed by short sellers. That could certainly explain their criticisms, whether they are justified or not. But short selling benefits society via market prices that more quickly and accurately reflect reality, not to mention provide more liquidity and reduced bid-ask spreads that make markets work better. As finance professor Joshua White said, “Academic research on that is very clear. If we didn’t have short-sellers in the market then the stock prices would potentially be too high,” or in the words of Tim Fernholz and John Detrixhe, “Studies have found strong evidence, around the world, that fewer constraints on short-selling contributes to more efficient markets.”
But the value of short selling in generating more accurate information doesn’t keep the misguided criticisms at bay.
Short sellers are portrayed as heartless opportunists, seeking and benefiting from bad outcomes. But they are no different from doctors who profit from our illnesses and teachers who benefit from our ignorance, or insurance companies who benefit from the risk we face. In fact, short selling provides added incentives to discover valuable information, which is often the scarcest commodity in a world of uncertainty and change.
Negative information is just as valuable for making the best use of scarce resources as positive information. When research leads investors to negative conclusions, short selling allows them to profit when they correctly anticipate the market’s response as that information becomes more widely known. It also allows those who are not currently stockholders in a firm to profit from the earlier discovery of negative information. In both cases, the result is that all of us make fewer mistakes from relying on less accurate prices. And short selling cannot depress prices long if underlying circumstances do not warrant it.
That payoff to negative information is why short sellers are often the most effective market policemen, often uncovering fraud, questionable accounting, and management misbehavior that regulators fail to detect or prevent. That is also why target firms often assault short sellers with attack ad campaigns and lawsuits. But a 2004 National Bureau of Economic Research (NBER) study revealed that targets often had something negative to hide because “firms taking anti-shorting actions have in the subsequent year very low abnormal returns.”
Short selling is also common in business. Farmers selling in futures markets when they plant do the same thing. So do home builders and others producing to order. As the New York State Commission on Speculation noted over a century ago, “Contracts and agreements to sell, and deliver in the future, property which one does not possess at the time of the contract, are common in all kinds of business.” There is no reason why such a commonly accepted business practice is harmful in the stock market.
Short sellers are also criticized whenever they are wrong, as in the case of GameStop (particularly because the big hedge funds did not take cover positions to limit their otherwise unlimited downside risk). But holding them to a standard of correct expectations is an impossible standard. No one has perfect foresight.
In sum, short selling is part of the information-revealing process that is the central advantage of the market process. In a world of uncertainty and change, information is the scarcest good, and short selling is an important source of additional information that would otherwise be lost.
Allowing short selling increases the number of people with an incentive to discover valuable information about firms’ prospects, by providing an added mechanism to benefit from information that turns out to be negative. Such information may not be as valuable as positive information for purposes of cheerleading, but it is just as valuable when people wish to make the best use of scarce resources.
There is no reason to assume negative information will be revealed to—or discovered by—those who are already owners of a particular stock. To attack or restrict short selling is then to restrict the market’s ability to elicit and integrate all available information.
Short selling, which allows profits to be made from negative information, is akin to another aspect of a competitive financial market—hostile corporate takeovers. Management groups who fail to make the best use of their company’s assets object to the prospect out of their own self-interest. But hostile takeovers provide a mechanism for even those investors who own no current shares in a firm to benefit from negative information. If a firm is poorly run, even someone with no initial position in a company can purchase shares at a price capitalizing its prospects under current management. By then accumulating enough shares, and taking over management, “takeover artists” can gain from eliminating inefficiencies and improving results. This expands the number of potential investors who have incentives to discover such negatives and “fix” underperforming companies.
Opposition to short selling also confuses correlation with causation. Selling short only lowers the price sooner than would otherwise occur. It cannot force the price down for long if the fundamental circumstances do not support it. Short sellers simply recognize negative information sooner. Their activity can begin the process of reducing market prices, but it is the negative information that causes stock prices to fall. And even when short sellers are wrong, they provide extra profit opportunities to those who expand their holdings at the temporarily low prices that result, a benefit ignored by those blinded by their exclusive devotion to “what’s in it for me?” Consequently, opposition to short selling is often no more than objecting to its effects on a particular stock that the opponent currently owns. The only principle involved is that of preventing any change that might lower the price of what one owns, ignoring the benefits to society from revealing more accurate information.
Short sellers are also attacked for allegedly spreading negative rumors that sometimes turn out to be false. But false positive rumors are regularly asserted by a far larger group who benefit by pumping up stock prices, from managers to brokers to financial talk show touts. But critics of short selling are only concerned about what they don’t benefit from.
Short sellers receive widespread condemnation. But it is undeserved. They take substantial risks to improve the information incorporated in market prices that we all rely on to improve social coordination as we seek to make the best of a world of unavoidable scarcity. The attacks against them are poorly thought out and often come from those whose real abuses or regulatory failings short sellers threaten to uncover. It makes more sense to sell their critics short than to sell them short.