As pointed out by the previous article, the practice of short selling has been around for centuries. It has been banned and vilified many times. It remains a controversial topic to this day. But how reasonable is the public’s ill perception of short selling? Is it really that bad or does it serve a purpose? Should it be banned outright or embraced? In this article we will be taking a look at both sides of the argument.

Bear Raids

A common argument against short selling is that short sellers often times spread misinformation with the hope of driving down the price of shares they have shorted. Isaac le Maire was the first person to ever sell shares short, and did so because of his animosity towards the Dutch East Indies Company. This is probably the first example of a “bear raid”. Such type of unscrupulous behaviour still takes place nowadays; however, it would be foolish to assume that it is exclusive to shorts. The truth of the matter is that most share price manipulation seeks to drive prices up. “Pump and Dump” schemes are common place in equity markets across the globe, particularly in the less regulated ones such the OTC in the USA (if you read our short reports you might notice a fair share of them feature OTC tickers).

Simply put, any financial practice can be abused with the aim of netting ill obtained profits, however, this does not mean that the practice itself is intrinsically corrupt or amoral. In the case of both “pump and dumps” and “bear raids” the problem is not the possibility of going long or short (money can be made in both scenarios either way), it is the manipulation of markets and the spreading of misinformation that results in unsubstantiated share price valuations, market inefficiency and investors being defrauded.

Worsen downturns

Another argument against short selling is that it can worsen stock market downturns. In 1938, during the Recession of 1937-38 in the USA, the Securities Exchange Commission (SEC) put in place the uptick rule in an attempt to prop up the stock market. The rule stated that an investor cannot short a stock if its price has decreased. It was repealed in 2007 but brought back in 2010 as the “alternative” uptick rule which states that a stock cannot be shorted if it has fallen by more 10% in a single day.

While it is true that the additional selling of stocks can worsen a downturn and short selling can exacerbate this, the exact same thing happens when the markets get carried away by bullish sentiment and bubbles are created. When these bubbles get very big and pop they can lead to painful adjustments as exemplified by the 1929 Crash, the dotcom bubble and the financial crisis of 2008. So, in a sense, banning short selling because it can worsen a downturn is similar to banning the purchase of shares because it can lead to a bubble.

Profit out of others losses

“Short sellers profit from others misfortune” is perhaps the most touted argument against shorts. There is something about profiting from others losses that rubs a lot of people the wrong way. In an ideal world, everyone would always win. But the world is far from perfect. In most cases when there are winners there are also losers, and equity markets are no different. If anything, equity markets are among the most volatile and most inefficient, meaning that who the winners and losers are often times does not reflect the underlying reality. There is strong evidence that short sellers improve market efficiency, so even though they may profit from others losses, at least their participation in the market can help mitigate unwarranted outcomes.

The efficiency argument

The efficiency of equity markets is thus of great importance. Market prices should reflect the underlying value of an equity, so that market participants can allocate their capital to the best of their ability and liking. In order for this to occur, publicly available information needs to be balanced. This would require full transparency from market participants. Unfortunately, this does not always happen. The corporate world is fraught with instances of management misleading investors by emphasising positive information while undermining or outright omitting negative information. After all, publicly listed companies who wish to attract investment in a fiercely competitive environment have a very strong incentive to keep their share price going up. In other cases, unscrupulous and amoral company executives, shareholders and third parties outright lie to the public by purposefully misstating information or outright fabricating it in attempts to sell overpriced shares to ill-informed victims. This bias towards positive information is likely to result in overvalued and inefficient prices at best, and investors that have been defrauded at worst.

Ideally, market regulators would do their job perfectly and intervene whenever these kinds of practices take place. But the sad reality is that regulators are often times underfunded, corrupt and/or inept, meaning that the only practical way to counter the bias towards positive information is to make use of market mechanisms to incentivise investors to research negative information and bring it to the public’s attention. Short selling has so far proved to be the simplest and most effective way to achieve this.

Short selling may not be popular or looked up to, but it is at worse a necessary evil and at best an integral part of a healthy financial system. Otherwise it would have been banned and remained banned a very long time ago.

In our next article we will going over some of the reasons why you should nurture your inner bear.