Short sellers have always been unpopular, and they managed to become even more hated during the GameStop controversy. But at a time when the stock market appears less and less connected to economic reality, these controversial investors are needed more than ever.
What is a short seller?
When investors think a company’s stock price is on a downtrend, they can bet on their belief by borrowing stocks from other investors, with the promise of returning the stock within a certain amount of time. more interest.
A stylized example: the short investor borrows a stock, say at $ 10, and sell it. When the stock price drops to $ 5 next week, they buy back the stock, give it back and pocket a profit of $ 5. If the stock increases to $ 15 instead, the short investor closes the trade for a loss of $ 5 or pays more interest to keep the trade open. For short sellers, the risk can be immensely with no cap on how high a security can skyrocket, meaning their losses can climb indefinitely.
The crazy rise of the stock GameStops first required many bets on its future. Investing enthusiasts on Reddit knew that hedge funds that shorted GameStop were vulnerable to short squeeze, as long as buyers could keep the stock price up, short sellers would eventually be forced to buy. GameStop actions to contain damage. When hedge funds do this (called short hedging) it provides another rise in stock prices.
There was another in-game feedback loop: Traders were also buying a lot of options for the GameStop action. Market makers selling options then bought GameStop shares to hedge against losses if the options paid off. This dynamic has created a demand vortex for GameStock inventory. As shares of game retailers exploded, at least two hedge funds closed their positions with huge losses.
Is Short Selling Bad?
Many people attribute a moral dimension to short selling. Often times, these are business leaders who don’t like to see people bet against their businesses, for obvious reasons. Elon Musk is our most famous contemporary critic of short sellers, who has targeted his electric car company Tesla virtually since its IPO. In response, Musk played with the privatization of the company and ridiculous merch product, but his real revenge was simply Teslas’ performance, which made him the richest man in the world. Former New York Stock Exchange chairman Tom Farley once said short selling was non americanbut again you can see why he was saying this: his job was to dominate the stock market.
So it’s interesting that many people who are not corporate titans also think short selling is bad. The idea of ​​betting against the success of a company can be seen as an attack on the workers of the company or other regular investors who bet on the stock. But this point of view is a mistake: Unless a huge percentage of your wealth is tied to a single business, short selling is better for the average investor because it repels bubbles and corporate malfeasance. Creative destruction is painful for workers, but their career prospects will likely be better as they move into a vibrant, healthy business and leave a corporate zombie.
Short sellers, when done right, are healthy for the market, says Joshua White, assistant professor of finance at Vanderbilt University. The academic research on this subject is very clear. If we didn’t have short sellers in the market, stock prices would potentially be too high.
This may sound ironic, as short selling indirectly created the GameStop bubble. But if there is one major complaint about the markets, it’s that they are too disconnected from the real economy. The valuation of some companies is no longer tied, even loosely, to their potential to generate future cash flows. Many complained as the US stock market increased billionaire wealth in 2020, even as the US had its worst economic performance since 1946.
One way to help keep the market honest is to sell stocks whose business plans don’t add up or whose activity is illegal. Studies have found strong evidence, around the world, that fewer constraints on short selling contribute to more efficient markets. This is not only because of more accurate pricing, but also because short sellers provide additional income to the long investors whose stocks they borrow, and because short positions are often used by sophisticated investors to hedge funds. other positive bets.
Here’s another way to think about it: the list of people who want stocks to rise is long – politicians, investors (individuals and institutions), business leaders, arguably even financial regulators have the incentive to want the stock market to rise. market rallies. The person with the only voice going the other way isn’t going to make a lot of friends, but that voice is important if you want the markets to find fair values.
Best short sellers
Bets against businesses are arguably even more important for people who care about controlling malpractice.
After corporate lobbying caused decades of intentional underfunding of law enforcement agencies, activist investors, including activist shorts, are one of the few well-funded investigators into the conduct of law enforcement agencies. companies, Brennan Bilberry, co-founder of Elk Hills Research, told Quartz. If you are rightly concerned about the worrying concentration of corporate power today, you should want more activist investors with a financial incentive to take on entrenched business management.
Consider the story of Wirecard, arguably the biggest corporate scandal of 2020. The German payment processor, a darling of the country’s fintech industry, drew public doubts about its financial reports as early as 2008, but regulators instead blamed the men who made the allegations. handling of stocks. Yet the questions did not go away, and after the Financial Times published a report, Wirecard accused the newspaper of collaborating with short sellers (it had not done so). The anger of German regulators at criticism of the company was such that the short-selling of its shares was banned for two months.
You may know how the story ends: in June 2020, Wirecard admitted that its books were fraudulent and were under $ 1.2 billion ($ 2.4 billion); its CEO is under arrest and its COO remains an international fugitive. Without the pressure from short sellers and journalists, this fraud would likely have continued without authorities being concerned.
There are other examples: Capitalizing on an investigation by nonprofit short seller Whitney Tilson took advantage of a bet against the firm Lumber Liquidators, which had nibbled its margins by buying cheap wood harvested from the habitat of endangered Siberian tigers and by selling wood contaminated with formaldehyde. Another short seller, Carson Block, rose to prominence while investigating Chinese companies listed on Western Stock Exchanges. frauds like Sino-Forest.
Can shorts go wrong?
In 2017, three bombs exploded near a bus carrying the Borussia Dortmund football team, injuring several players. An investigation has revealed that the culprit, Sergej Wenergold, had placed the explosives in an attempt to bring down the football team’s publicly traded stock. He had bought put options on financial instruments related to short sales that represent a bet on the fall in the price of a share. But the stock did not drop precipitously and Wenergold was sentenced to 14 years in prison.
This short sale will lead to actual sabotage is often claimed by CEOs whose companies are under pressure, but there are few substantiated examples as dramatic as this one. On the one hand, the initial cost of options is quite expensive for most criminals (the Wenergolds cost 78,000) and the transactions are fairly well monitored by regulators.
Another protection against pernicious outcomes is regulation aimed at curbing market manipulation. After the financial crisis, the SEC tightened US rules on short stocks to avoid short selling, the practice of betting against a stock without actually borrowing the underlying security. The United States also added another rule, the rule of the rise, to prevent short sellers from accumulating on a declining stock.
In practice, these characteristics make short selling a rather risky investment strategy. Even strong evidence of fraud may not be enough to shake market confidence, and more often than not short-term investors make more subtle arguments about a failed business model. Bill Ackman, hedge fund investor past five years trying to convince the world that Herbalife was a pyramid scheme, and failed. Tesla has yet to be lowered by short sellers. And like GameStop antagonists, short sellers are always vulnerable to squeeze, like the one who briefly makes Volkswagen the most valuable company in the world In 2008.
It’s not easier for short sellers. Last summer, Block told Quartz that it has become increasingly difficult to communicate its messages about fraud and overvalued companies with investors, even as the stock market becomes increasingly lopsided compared to economic reality. I feel like the bar is rising every year, just so I can tell stories about companies that engage investors and that they think are important, he said.
A company known for its strategy, Citron Research, which was burned during the GameStop short squeeze, says it will stop posting short research. Founder Andrew Left said the company will now focus on recommending stocks it deems promising.
Short sellers are probably used to seeing themselves as the Davids against the Goliaths of other interests, from politicians to business executives. In a bizarre twist, short sellers now find themselves being hunted down by armies of retail investors, and the public and political class are mostly siding with the retail traders. Understandably, it’s hard to get a lot of sympathy for hedge fund managers. But the biggest risk to the market is a populist backlash that places new limits on only those who are made to speak out against bullshit rather than support it.
