Short-selling is a hot topic again thanks to the battle between Citron’s Andrew Left and Valeant Pharmaceuticals that’s captured the business press’s attention over the last week. We had Andrew Left on our show yesterday and it was one of the best segments we’ve done all year (full video here).
I’ve gotten a bunch of questions from people about short-selling and whether or not its good for the market or “it should be illegal” etc. I’ve written on the subject before but today I’ll give you the abbreviated version:
Short-selling is good for the market.
Short-selling is one of the oldest forms of speculation and it’s been an essential ingredient for American capitalism since the beginning.
Short-selling aids in price discovery.
Short-selling can be abusive but so can anything else – buyers can be manipulative too and no one is looking to outlaw buying.
If a short-seller calls out a company for shady dealings and is right, then that short-seller has done the markets a public service. If the short-seller ends up being wrong, then they get their ass kicked and lose money. Either way, the truth comes out in the end.
A short-seller that becomes known for manipulation or being wrong ceases to hold influence over the market and, as a result, becomes less dangerous.
Some of the smartest investors I’ve ever met (and I’ve met them all) are skeptical by nature and run either long/short funds or short-biased funds. They are taking a huge risk in doing so, as markets go up in 3 out of 4 years. They deserve to make money when they’re right in light of this heightened risk.
Bans or temporary bans on short-selling don’t actually work and, in some cases, are counterproductive to the aim of stabilization. We have living proof of this in recent history from around the world.
The one exception to short-selling being universally beneficial is in financial stocks or CDS. Financial institutions – especially investment banks – can be permanently damaged by unchecked short-selling. This is because of what George Soros calls reflexivity – meaning the action in the trading markets can actually dictate the actions people take in the real world. The lower the stock price of a bank or brokerage is driven, the more market participants will shy away from being a counterparty to that bank or brokerage. In other words, traders can put a financial company out of business simply by creating the appearance that it is going out of business.
Amateur short-sellers are ridiculous and typically use indexes or bet against high-flying stocks because of “valuation”. They are usually carried out of the exchange feet-first.
Finally, and most importantly: Ordinary investors should not be shorting stocks. Of all the ways to hedge a portfolio, it is probably the riskiest one with the lowest potential payout. Newsletter services that convince regular investors that they should be shorting stocks to manage risk are toxic and embarrassing. Cash and / or Treasurys make for a more practical hedge for the majority of investors. Some other superior forms of risk management include position sizing, stop loss orders, diversification or tactical asset allocation.