Bull/Bear Report - Short selling: Good or Bad?

Given all craziness in the market over the last two weeks, I thought it appropriate to change the focus of this column. Instead of examining a specific stock, I wanted to know how the community felt about short selling and the temporary ban thereof.

Are short sellers to blame for creating this financial crisis? Is the temporary ban of some 800 stocks are good thing or a bad thing for the market?

There are no easy answers to this question. In fact, I'm not sure those regulating the market know the answer. It is a very complicated issue.

My own personal beliefs on the subject are too complex to discuss here. I am stridently in favor of free market systems with little government interference. That being said, I worry greatly about market manipulation.

At the end of the day, I believe that short selling by large money managers greatly increases the risk of manipulation. If that manipulation creates a crisis of confidence that can destroy solvent entities, I'm not sure the benefits of short selling are worth the cost.

Ultimately, I have a hard time believing in the utility of short selling. A market is efficient when there is a willing buyer matched with a willing seller. In most cases both the seller and the buyer have a vested interest in the entity being bought or sold.

With short selling, there is simply a speculation on prices that prices of underlying securities will fall. Certainly money is at stake and there is a borrowing of shares that creates the vested interest, but...

I don't want to get too altruistic, but short selling somewhat defeats the purpose of efficient markets. It is all about greed and not about production. Yes, greed is good as made famous by fictional character, Gordon Gecko, but we now see the consequences of that greed.

Jamie paints a "not so pretty" picture and gives you our bloggers' take on short-selling in this week's Bull/Bear Report. Read more...

It is not pretty. So here we are today with a short selling ban that appears to be working very well. I find it interesting that those complaining the loudest are those short sellers that have seen the gravy train end.

Of course the ban is temporary and the impact on stocks may still be felt when the ban is ended. We really don't know how this all plays out at the end of the day. Personally I would be in favor of a permanent ban.

The risk of manipulation and the consequences thereof is too great in my opinion. Shorts would still be able to operate with options and futures. Get them out of the stock market!

Here are your views:

Don Moncrief
I have many times spoken out to say short selling should be stopped, not just for select companies, but all companies. That is not to say that I am so naive as to believe it is the whole problem with the market right now. It does however go hand in hand with many other factors, and the combination has been proving deadly to the market as a whole. And, one reason I stand so steadfastly against short selling, is it is the part of the equation we can fix easily enough, just by halting it altogether.

The other big issue here, is we have HUGE hedge funds, and virtually all of these not only process short selling (legally or not), but they also have LARGE volumes of stocks. Enough in many cases, of a single stock, to have significant price control on the stock, even if just for a short period of time. Combined with short selling strategies, a short period of time is all they need. Buy the short, when they have the stock, then dump the stock in volume, to force the price down. The short becomes a self-fulfilling prophecy.
So, the issue becomes fairly clear to me. Very simply, hedge funds, and investment institutions should be banned from ALL short selling activities. It becomes quite clear that we can not limit them from owning stocks, as collectively, that is what the fund is designed to do anyway.

Shorting stocks is basically options trading anyway. So, why not regulate it so it is truly a useful market tool, like it was supposed to be in the first place. It got it's origin from the commodities markets, where companies truly needed to fix prices in the future, because the needed the resources to be guaranteed to be available, and to get higher/lower prices (depending on if you are a buyer or seller) for a specific item. So, the simple regulation needed, is if you need to be in this kind of a market at all, you must show proof, by taking possession of the item, or producing the item. No, I am not saying it has to be EVERY time, as that is not what the hedge is all about either, but a significant amount of the time. And I would make that a fairly high percentage, like 75% of the time. So, very simply, option traders have to register for a specific commodity, as only they can be option traded (all other options trading is banned), and they must show proof of intent to supply, and/or buy the commodity in question.

The beauty of this is it can be uniformly applied to all businesses. Hedge funds can't do it, unless they plan to build grain silos, oil reservoirs, or whatever, and I think that would have to be regulated to keep them out, but few would really want to. Their goal was always to make money, without ever taking possession anyway.

Now, this does not really do much about the problem that brought this market down so drastically in the first place, and to remind you, it was mortgage banks selling unsecured mortgages to unqualified buyers. Then to make the situation worse, these same institutions, sell packages of these mortgages that can no longer be fairly priced, to large brokerages.

And, because the housing market had been so dependable in the past, those scooping up this now hideously bad debt, were insurance companies, investment banks, and funds of all kinds.

And, we are now seeing them fail, left and right. Keep in mind, they reaped in the good times, so my compassion is not high for them in the bad times. In fact, I get down-right angry about it at times. They have caused a significant unemployment problem, and have been a leading cause of large reductions in the financial funds many need for retirement, to say nothing to being a leading cause to the huge devaluation of the dollar. Yes, every time the government spends our taxpayer money for some undeserving bailout (and they are ALL undeserving, no matter how much it may need to be done), the dollar value dwindles.

Not so long ago, this country took on a war against terrorism, yet today, we are handing our American lifestyles away hand over fist, to foreigners, with every dive in the value of the dollar.

The cheaper dollar, allows them to buy in at reduced prices, reap profits, and support the terrorist activities they do anyway. We are just making it way to easy for them. No, not all foreigners are terrorists, so don't get the idea I mean it that way. But, if even ONE is, do we want to continue to make things this easy for them? We are helping them win, and I for one, want to see it halted, in any way we can.

Regulation of short-selling is a beginning. It is not a cure all. The problem is complex, and the solution will be too. But, having the government bail out businesses is not the right answer either, as there is a significant cost to that, not to mention putting the government in places it does not belong in the first place. But, the government can, and should, make some simple rules to govern short selling, and what they have now is pitifully inadequate. That, in fact, really is what the government is for, (rather than to play who is our chosen bank today). And, the fact that they have not done so so far, is in my book, cause for heads of the SEC, Federal Trade Commission, and several others to be in an unemployment line somewhere.

Jonathon Coyle
To all short sellers: Please address the following:

1. If selling short drives prices downward, do they not also hold rising prices down?
2. Oil cracked $150, then plummeted to under $100 in less than 2 months. What role did the shorts play in this price action? What role did the shorts play in the Monday rise in oil price?
3. Is it beneficial to give a financial incentive for individuals to identify problems in companies?
4. Name 3 advantages of the existence of shorts.
5. Name 3 disadvantages of the existence of shorts.
6. How do shorts lock in their gains? What happens to the stock price when they do?

I will put forth the following: All of the individuals whining and crying about short sellers are those individuals who have portfolios going into the toilet right now, which is clearly affecting the function of the neurons misfirings in their brains.

It's true, misery loves company. If your portfolio is getting hit, bitch about short sellers and that may make you feel better-for a while. The problem is, after all the bitching, the situation remains the same and you have made yourself look like an uninformed ass in the process. And after all is said and done, it hasn't added one cent to your coffers. Better for you to spend your time re-grouping.

The above 6 points aren't part of some simple stock shorts 101 test. The questions hit at the very essence of short selling, when you actually take the time to answer them. Short selling is akin to Newton's third law of motion...every market force has an equal and opposite force. The only difference is that you can't go below zero in stock price whereas the ceiling is limitless. This illustrates the risk that the shorts take, and the risk when "oversold" hits zero. But I digress slightly. . .

If you honestly answer each of the above questions, there is no way you can go about claiming that the shorts are evil, immoral, unpatriotic, and should be banned.

Yes, I think a temporary ban of shorts to limit panic selling and capitalizing on rumor mongering is prudent. After all, if a company is truly bad enough to go to zero, then delaying things by a week or a month will only delay the inevitable. If the company isn't fundamentally flawed, a delay of short selling will prevent an oversold condition hitting zero, thus preserving the company. Yes, I believe anyone that intentionally tries to manipulate stocks by spreading rumors (long or short) should be prosecuted to the fullest extent of the law. There are rules on the books, and they should be enforced, plain and simple. I do not oppose circuit breakers that will halt the markets in the event of panic selling. Again, it is another prudent device in place to help us when we aren't being rational, and it allows us the time to round up those buyers (Buffett like types) to come in when no one else has the stones to buy.

Short seller haters never make the above distinctions--never. They never distinguish between legitimate short selling and illegal activity. "Shorts" and "illegal" might as well be synonymous.

Short seller haters try to make people believe that perfectly sound companies, those with solid books and great business models can somehow be easily taken out by a rogue short seller. HOGWASH!

The shorts are no more "bad" or "wrong" than long sellers. It is all about what side of the trade you are on. By the way, in regards to the price of oil, shouldn't all of you short haters be thanking the shorts from keeping oil from rising past $150? Or, shouldn't you thank the shorts for the decrease in oil price? Oh, I get it. The shorts are bad only when I lose money out of the deal, am I reading that right? You people need to pull your head out of the sand, or whatever orifice it may be residing at this time. Maybe you should just say "thank you", and then get on your way and trade. There is rarely substance to the blanket anti-short arguments. Bitch all you want about the illegal activity of spreading rumors for profit, in which I am in agreement with you, but the act of short selling isn't the root problem. Taking away the shorts takes away information from the market, plain and simple. Maybe those long sellers should hang tough as these evil short sellers are pushing the price down and not sell themselves. That's another point never addressed by the short haters . . . it compounds their market view so it is easier to ignore. Also ignored are stocks that have been shorted and publicly lambasted, yet are resilient. (Maybe because the management wised up and made changes?) Short interest levels are also ignored, but only when the short interest does not suit their market view. Otherwise, it is shouted from the mountaintops.

Just admit it, short haters. Your portfolio is in shambles, and you're looking for someone to blame. A little honesty goes a long way.

--Jonathan

p.s. and yes, I have read Tom Armistead's Moral Hazard--A Danger to our Financial System (sic)

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Short selling is a complicated issue. I can see both sides of the coin. We'll have to wait for temporary ban to end to see the ultimate impact. At that time we can revise our opinions.

Jamie Dlugosch
Executive Editor, InvestorPlaceBlogs

by The Freshman |  09/26/08