Coyote Blog

Is there anything that rankles populists who are "anti-speculator" more than the ability to short stocks?  From time to time countries that are upset about falling markets will ban short-selling.  But I have defended stock (and other asset shorting) as a critical market mechanism that helps to limit damaging bubbles.  I wrote waaaaaay back in 2008, after the US temporarily banned short selling of certain assets:

At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements.  For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset.  They start buying the asset, and the price starts rising.  As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers.  The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more.

Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios.  The ownership base for the asset is now disproportionately
made up of those sky-is-the-limit bulls, while everyone who thought these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued.  But how does it come to earth?  After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so.  As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.

Thus, we have short-selling.  Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote [on] the value of the company.  Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.

I am remembering this old post because Arnold Kling links an interesting bit on economists discussing the Big Short, who among a number of interesting things say this:

Shorting the market in the way they did is very risky, and one has to be very confident, perhaps overconfident, in one’s forecast to take such risks. As a consequence, many people who were pessimistic about the housing market simply stayed on the sidelines—which in turn meant that for a while, valuations in the market primarily reflected the beliefs of optimists.

The timing issue is key.  I have been right probably in 4 of out the 5 major market shorting opportunities I have identified in the last 10 years, but have been on average 2 years early with all of them, meaning I lost money on most of them, or made money after enduring some really big paper losses for a while.

I am fascinated by Bitcoin and would love to see it be a success.  But Tyler Cowen has a quote that reflects some of my concerns about it:

…bitcoins are an uncomfortable combination of commodity and currency. The commodity value of bitcoins is rooted in their currency value, but the more of a commodity they become, the less useful they are as a currency.

Bitcoin is in the midst of an enormous price bubble, with increases in value of as much as 50% over just a few days.  This is astounding volatility for even a commodity, much less a currency.

Cowen said something at the end of the post, almost as a throw-away, that got my attention:  "There is, by the way, no current way to short Bitcoin."  The reason this caught my eye is that I have argued a long time that short selling is an important mechanism to reduce market volatility.

Every time we get to a market bubble or problem, insiders always start arguing against short selling saying it makes volatility worse and undermines markets.  But what they are really saying is that they like volatility so long as it is up. They had no problem with the bubble that propelled their securities up, they just don't want them to come back down to Earth.

In certain bubbles, when interest in a certain asset class gets really frothy, anyone who is skeptical of the asset and its new high values will sell and get out.  This means that as the bubble grows, all the skeptics are long gone from the market.  No longer owning the asset, these skeptics have no further "vote" or influence on the price.  Short selling is a way for skeptics to continue to influence the price and asset values.  To this extent, I think it tends to limit the peak of bubbles, just as bottom-fishers limit the debt of troughs.

Bitcoin would likely benefit from skeptics having some sort of influence on bitcoin values.  But without a way to short, Bitcoin values are driven solely by wacky anarcho-capitalists (e.g. people like me) and people fearful of Cyprus style depositor losses.  Essentially all the true believers are bidding against themselves.

...when they ban short-selling.  As a response to economic problems, banning short selling is roughly equivalent to banning criticism of the government during a political crisis.  Or perhaps more accurately, its like trying to improve poll results by not polling people with negative opinions.   Short-selling has utility for the actual traders involved because it helps them achieve whatever financial or risk-management goals they might have.  Short-selling has utility for the rest of us because it allows the full range of opinions to be expressed about the value of a particular company or asset.  Nothing in a market economy is worse than having prices that have no meaning.

It is pretty much a law of nature that issuers of securities hate short-selling.  They have tried for years to paint it as somehow unethical or at least unseemly, though it has always befuddled me as to why short-selling is any different than taking a long position on a security.  In both cases one is making a bet on future prices of the underlying asset, the only difference is in the direction.

But issuers of securities, whether they be corporate equities or government bonds, generally have strong personal incentives to see asset prices go up, or at least remain flat.  No CEO thinks short-selling is justified, but in fact the ability to sell short is critical to having quality pricing signals (see below for a discussion of how short-selling helps limit bubbles).

Of course, Corporate CEO's may gripe about short sellers, but they basically have to just live with them.  But governments are different.  They can actually ban what they don't like and have done so now in Germany.  What's next, a law saying that once you have bought a government security you are never allowed to sell it?

Postscript: Here is an example of how short selling reduces volatility.  First, some background

Chester Spatt, who was chief economist at the U.S. Securities and Exchange Commission from 2004 to 2007, said that Germany's short-selling ban would probably end up causing more market turbulence and not less.

"Like many types of well-intentioned regulation, this is likely to misfire," he said in an interview. "During our financial crisis in 2008, there was a ban on short-sales for about three weeks .... That ban was very counterproductive. It didn't help stabilize asset prices at all."

Here is an example of why this happens, as I discussed in an earlier post during that temporary US ban:

At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements.  For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset.  They start buying the asset, and the price starts rising.  As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers.  The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more.

Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios.  The ownership base for the asset is now disproportionately made up of those sky-is-the-limit bulls, while everyone who thought these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued.  But how does it come to earth?  After all, the only way the price can drop is if some owners sell [remember, we are discussing a world where naked shorting is banned], and all the owners are super-bulls who are unlikely to do so.  As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.

Thus, we have short-selling.  Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote for the value of the company.  Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.

Without short-selling, the only folks involved in the price-discovery process are those who have self-selected as being more bullish than average.  Short-selling vastly broadens the number of people, and thus the perspectives and information, involved in the pricing process.

I think "cargo cult" is a great moniker for this kind of regulation.  The price of European bonds are declining as lots of people sell?  Then lets ban selling, that will take care of the problem.   Just ignore that large government deficit behind the curtain.

Repeat after me:  There is nothing wrong, immoral, evil, or even unsavory about short-selling.  No one gets mad at you for selling an over-valued security which you actually own, so there should be no ethical difference in selling an over-valued security you don't actually own.  Somehow people who are traditionally long in the market (e.g. corporate executives) have convinced the world that short-sellers should be vilified.  I don't understand it.  If you love the stock and short-sellers drive it down, you should treat it as a gift that the stock you love can now be bought more cheaply.

So I thought this was particularly awesome:

On Oct. 8 and 9, 2008"”as the Federal Reserve was bailing out American International Group Inc."”an account Sen. Isakson held invested more than $30,000 in ProShares UltraShort 7-10 Year Treasury and UltraShort 20+ Year Treasury, the records show. These are "leveraged short" funds, designed to gain $2 for each $1 drop in the daily value of U.S. Treasury bonds.

Isakson claims he was not actively managing the account, a claim that is probably true given the ethics rules in Congress (not that anyone follows those).  My response in his place would have been, "F*cking-A right I was shorting government bonds.  Haven't you been paying attention over the last 12 months?"

Unfortunately, Isakson falls out of my hero category into my "hypocritical goat" category for this:

In February, Sen. Johnny Isakson (R., Ga.) argued on the Senate floor that "we don't need those speculating in the marketplace to take unfair advantage of the values of equities that are owned by Americans all over this country for the sake of making a buck on a short sale."

Again this unaccountable bias that somehow people who are long are morally superior, and somehow more entitled, than people who are short.

Ht Radley Balko

Apparently, the Obama administration may soon put limits on short-selling.  If so, this is cargo-cult thinking at its worst.  Prices fell really fast, so it must be the sellers' fault!  If we could just stop all this selling, then prices would never go down!

Here is my previous explanation of why short selling is in fact a critical tool to moderate bubbles, adding to the irony that we should be considering limits on this tool while suffering a bubble-induced recession.

At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements.  For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset.  They start buying the asset, and the price starts rising.  As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers.  The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more.

Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios.  The ownership base for the asset is now disproportionately made up of those sky-is-the-limit bulls, while everyone who thought these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued.  But how does it come to earth?  After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so.  As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.

Thus, we have short-selling.  Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote for the value of the company.  Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.

Megan McArdle hilariously commented:

I don't understand why the Commission doesn't focus on something more effective, like installing lavish statues of Mammon on trading floors so that traders can better propitiate him.

Update: By the way, this could be argued to be just another piece of corporate welfare.  CEO's hate short sales of their stocks, and would love Congress to ban the practice altogether.  The fact that the practice enforces accountability on them, I am sure, has nothing to do with it.  The reality is that if buying and selling are thought of as voting for or against a company's or asset's value and prospects, then banning short selling is a way of disenfranchising most of the world from this process.

By the way, not that I think it should matter from a policy perspective, but have you noticed that the shorts seem to be right an awful lot?  In retrospect, more shorting of bank and insurance stocks 3 years ago would have been a good thing.

OK, I know burn-out is setting in.  I certainly think that explains, in part, why the House voted for a demonstrably worse bill than they voted against the week before.  But John Moore has a number links to an interesting set of charts from the Milken Institute on the financial meltdown.

They hit on many of the things I discussed earlier, but put a greater emphasis on 1) securitization, and the effect it had on good underwriting standards and 2) on interest rates as a driver of the housing bubble.

Update:  And an interesting post on the link between credit default swaps and short-selling.  My personal view is that credit default swaps will someday be looked at like earthquake insurance -- nice premiums today, but too much systematic risk, too much certainty that in 10 or 20 years there will be an event that forces nearly every policy to pay simultaneously, wiping out the insurer.  You can't get earthquake insurance, and you nearly can't get hurricane insurance, and I think the default insurance market may go the same way.  Or, as a minimum, the price is going so high few people will buy it.  This is not a market failure, it is a market lesson learned and adjustment to reality.

Update #2:  Even more from economists on the rush to bailout.

Someone noticed that just before certain stocks crash in value, there is a lot of short-selling.  So the US government has banned short-selling, at least temporarily.  Classic cargo-cult logic. 

Boy this sure makes perfect sense in a time when we are concerned about speculative bubbles -- let's ban one of the most important tools that exist for bubbles to be shortened and made less, uh, bubbly.  Here is why (very briefly and non-technically) short-selling takes the edge off speculative excesses.

At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements.  For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset.  They start buying the asset, and the price starts rising.  As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers.  The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more. 

Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios.  The ownership base for the asset is now disproportionately
made up of those sky-is-the-limit bulls, while everyone who thought
these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued.  But how does it come to earth?  After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so.  As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.

Thus, we have short-selling.  Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote for the value of the company.  Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.

Update:  From Don Boudreaux:

To ban short-selling of stocks is to short-circuit an important
mechanism through which people share their knowledge and expectations
with others.  Banning a mechanism that better allows share prices to
reflect the expectation that the underlying assets are not worth as
much as current market prices suggest does nothing to change the
underlying reality.  Such a ban merely distorts knowledge of this
reality