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Capitalism 2.0: Value Creation vs. Value Destruction

Posted on Saturday, Apr 4th 2009

In the Creator vs. Speculator debate, there is also the need to deal with the issue of when speculation becomes a way of value destruction as opposed to value creation.

One of the problems that we have with Wall Street compensation is that traders make money both as the market goes up and as the market goes down. And often, a tremendous amount of market manipulation is going on in the process, destroying many people’s honest, hard work.

Jim Cramer has openly described mechanisms used by hedge fund managers to manipulate stock prices. He also points out that some hedge fund managers spread false rumors to drive a stock down. In his days as a hedge fund manager, he did it too.

I have been thinking about the short-selling issue for a while, and have pretty much come to the conclusion that short-selling needs to be banned. No one should be making money if a company’s stock is going down. And especially, no one should have the incentive or the tools to bring a company’s stock price down.

The common counter-argument I have been hearing is that short-sellers keep the market in check, and prevent bubbles. My response: that is the job of analysts, to ensure that bad news, problems, concerns, etc. are reported.

And finally, the P&L is a perfectly sound mechanism to gauge company performance, unless it is cooked. And since cooking books is illegal, I believe that we have all the mechanisms necessary to keep markets in check without short-selling. Without value destruction.

And, if we prevent value destroyers from making money by destroying value, Wall Street compensation – compensation of the speculators – will also fall in alignment with those of the creators.

I know this is a controversial point of view, and I welcome debate on the topic.

This segment is a part in the series : Capitalism 2.0

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Hello again,

“And, if we prevent value destroyers from making money by destroying value, Wall Street compensation – compensation of the speculators – will also fall in alignment with those of the creators.”

My understanding is that value destroyers(gamblers in this case) always lose money on the long run(they take, and eventually get taken). But I surely appreciate if the system is improved not allow this to happen anymore.

Rafael Saturday, April 4, 2009 at 1:28 PM PT

PS: Investors generate wealth(for others) using their wealth(and this comes back),
while gamblers take from others(through gambling) and eventually get taken back. To
me, it bottoms down to which internal attitude they have, which determines if they will
attract true investments or not.

Rafael

Rafael Saturday, April 4, 2009 at 3:55 PM PT

Enron cooked its books for years and some short sellers like Jim Chanos were smart to figure this out reading the same 10Q’s and 10K’s that sell side analysts saw but had no clue what was going on.

Actually good short sell traders are probably the smartest analysts on wall street, precisely because they look at the companies with a very critical eye looking for trouble – may it be outright fraud or games being played like channel stuffing etc. Sell side analysts are inherently conflicted, their job is to sell stocks and convince main street to buy stocks, it is too naive to expect them to cover stocks objectively.

In my experience good short sellers are the best minds in the industry, good examples like Jim Chanos (above) he saw thru Enron and even the banking sector in the last 2 years. Herb Greenberg who was a columnist for CBS Marketwatch is another great analyst who precisely looks for the companies where something does not look right.

Should these smart people and their clients not be able to profit from betting that the stocks will fall? Of course they could do the same by buying puts but often times although you may know a business is in trouble there is know way to know when Wall street will wake up and figure out the truth, Jim Chanos was short on Enron for two years before the company came tumbling down.

Banning short selling is too blunt an instrument just because some manipulators have used it. Banning of naked short selling, which I believe is already in place should be adequate.

Ashish Kelkar Saturday, April 4, 2009 at 5:44 PM PT

Hmm, here I have to go again…

With all due respect, I will have to say that you’r point of view here is very subjective, narrow and almost Utopian!

Your argument is based on the premise that stock prices are never unduly boosted by ‘false’ good news or overly optimistic forecasts.
Its always the ‘shorters’ that have an incentive to spread (bad) news about a company to exploit the situation.

Let’s take an example to highlight this. If Amazon says they are confident of selling a 100 million Kindle devices in 5 years, you as an investor will take their word for it, compute the ‘rosy’ future earnings and value their stock at 70+ times future Earnings.

On the other side, a more ‘practical’ investor like me would be apprehensive about Amazon’s claim based on genuine competitive concerns (what if Apple or Google launches a more comprehensive reading device at much lower price point). What do I do?
Two options – 1. not invest my money in Amazon and let the ‘naive’ investors be taken for a ride with the high valuations..
2. Short the stock in expression of my pessimism to the company’s claim about their glorified prospects and hopefully make money expressing my opinion. In doing so, I’m helping bring Amazon’s stock price to more reasonable levels – that’s an equilibrium point between buyers and sellers.

I hope my argument provides some semblance of a justification towards the need for ‘short selling’ as an integral component of ‘free markets’ and thereby ‘Capitalism 1.0′.

Philosopher Saturday, April 4, 2009 at 6:27 PM PT

Ashish, what you point out is yet another systemic problem: the lack of analysts without conflict of interest.

In my opinion, there needs to be a class of analysts whose job is to do investigative research and offer both sides of the issues in companies.

Short sellers are the best minds in the business because they have an incentive to focus on that.

What if you took those minds and applied them to constructive things?

Sramana Mitra Saturday, April 4, 2009 at 10:05 PM PT

Philosopher, If Amazon announces bullshit forecasts, and I have some judgment, as an investor, I would simply not buy the stock, or take advantage of the market movement and sell it at the high.

I don’t see why short selling is necessary. Simple buying and selling offers all the instruments necessary for a “market” to operate.

Sramana Mitra Saturday, April 4, 2009 at 10:08 PM PT

You are completely wrong about short-selling. The valuation of the company does not go down because of short-selling. I think it is important to read the academic finance literature before coming to conclusions otherwise your views will be colored by current herd emotions. OK, I will write an article on this, hard to respond to this in a short note. Again intelligent people are expected to not be swayed by current fashions. Much of what you hear today is old socialist wine in a new bottle. Garbage.

Kishore Jethanandani Saturday, April 4, 2009 at 10:32 PM PT

Should we disallow options on a stock too? If I sell a call option or buy a put option. I will make money if the stock goes down.

Jagdambha Bilasia Sunday, April 5, 2009 at 12:06 AM PT

Kishore – Be careful about your attitude. This question about short selling / value destruction is being asked at most intelligent circles these days. If you want us to take you as the epitome of intelligence, I am sorry, I cannot do that. And if you ask me to not question what I feel requires questioning, I would have to discard that as what it is. Garbage.

Jagdambha – I am not an expert in trading. I would like to keep my participation in this debate at the philosophy level. On technicalities, I will have to look for experts who can throw in more light. and more informed detail.

To net it out, I think, we need a system that does not create an incentive structure geared toward value destruction. That’s what I wanted to highlight in this piece.

Sramana Mitra Sunday, April 5, 2009 at 12:18 PM PT

Btw, I just found this article on WSJ about Larry Summers: http://online.wsj.com/article/SB123879462053487927.html#articleTabs%3Darticle

Looks like he is minting money off Hedge Funds. What is the chance that he advises Obama objectively on this issue?

Sramana Mitra Sunday, April 5, 2009 at 2:03 PM PT

I have long believed that short selling is a destructive force in the markets. Rather ask investors to buy or not buy stocks; it s enough.

greg gianforte Sunday, April 5, 2009 at 3:22 PM PT

In my opinion, there needs to be a class of analysts whose job is to do investigative research and offer both sides of the issues in companies.

Jason Price
jprice@walkersresearch.com
http://www.walkersresearch.com/emaillists.asp

Jason Price Sunday, April 5, 2009 at 10:48 PM PT

I think at the heart of this discussion is misuse of an facility – which is the ability to borrow stock and sell it with a promise to repay the borrowed stock back at a later date.

This facility can be used for good, by allowing people to hedge their gains. For example, if I had worked for apple for 10 years and now had a million dollars of apple stock. I may want to protect that but not sell. I could do that with the use of options. Which in turn are based on the same borrowing and selling of stock.

So while I do not agree that we should do away with short selling in general, but I do agree that we do need a way to restrict unregulated financial engineering that turns investing into gambling and the stock markets into a global casino.

The short sellers don’t always win, but even that is equally bad. If you recall the VW episode.
http://www.nytimes.com/2008/10/31/business/worldbusiness/31norris.html

BTW : Maybe its time we brushed up on some option theory (just kidding ;)

Jagdambha Bilasia Sunday, April 5, 2009 at 11:59 PM PT

First, I’m not sure banning short-selling in the US would work. As another pointed out, one could use derivatives to constructively short most names. And, in normal economic times you could go offshore and short most US names if it weren’t also banned abroad.

From a practical, operational, point, unless there’s sec-lending in the post-disclocation world, there’s be significant curbs on lending as the major custodial banks won’t have securities to make a market. Their clients, locked in sec-lending arrangements, can’t get out fast enough. Just read some of the press on STT and NTRS.

Third, since when did secondary market trading ever create value? Issuing securities creates value, re-trading them is always speculation to some degree as there are two sides to every trade. The seller thinks the future of the stock is down, the buyer up. Just because you don’t own it when you sell it doesn’t make it speculation, anymore than buying long any distressed company.

Short selling is a lot like liquor. It looks like a sin, but regulating it away won’t make people not drink.

pesc Monday, April 6, 2009 at 5:54 AM PT

I am most of all in agreement with Jason’s point above: there needs to be a class of analysts whose job is to do investigative research and offer both sides of the issues in companies.

And these need to be people without a trading position in the stocks they cover, so that no conflict of interest exists. This means, these analysts should not be sitting inside banks that are also trading the same stocks.

They need to be truly independent entities, and adequately compensated to be so.

Sramana Mitra Monday, April 6, 2009 at 9:44 AM PT

If we ban short selling we should also ban buying stock. You don’t complain when I short a stock, the stock you are trying to buy and give you the liquidity you desire. Value creation? don’t you mean bubble inflated phantom money, like the housing market.

What a waste of my time reading your writing has been. You’re obviously not a trader because you would have back tested your theory before producing this garbage and seen that the ban on short selling financial stocks last year didn’t work. I have a theory of my own. You were long some stock that you read was upgraded by an analyst. This stock had a 25% short interest but you didn’t know that because you don’t do research to find out what the market sentiment truly is, instead you bought because Goldman’s analyst said to buy (Goldman and more shorts sold it to you). You lost all your money in the trade and you cant get your head straight. You have a major case of writers block but are on a deadline to produce an article so you can pay the mortgage you are upside down in because you listened to someone instead of doing your own due diligence and got a ARM mortgage. Maybe if those pesky short sellers weren’t here to correct the bubbles your house would still be going to the moon, the economy would be flying high and you wouldn’t be under this pressure. If you admit you’re an idiot and this happened to you then we will all forgive you for writing this garbage and spreading propaganda.

The problem isn’t short selling it is regulation and leverage. Cramers and idiot too, a back flipping monkey with clashing cymbals in his hands. Cramer is like getting your news from the E channel. I wish I could short sell your writing career.

Jason Monday, April 6, 2009 at 11:01 AM PT

Affirmative.

In its most simple form, short selling is a wager and our equities market is not, nor was it ever designed to be… a casino!

Mom & Pop investors who actually own shares in the best companies of the U.S. and the globe are made to endure increased volatility while some “gambler” sells something for which they do not hold “rights of ownership”… one of which is the right to sell. Try borrowing your neighbors car so that you can sell it now… only to buy it back again when it depreciates further.

Short sellers introduce an additional (and in most cases, unwanted…) level of volatility into a market that has been universally described as a “long-term” investment vehicle. While the same net effect of a short sale could be accomplished with the purchase of a “put” option, short sellers, driven by rapid profit desires, avoid the option premiums and the expiration dates by driving prices downward (market makers watch short positions intently) in what should, by law, be only a three day period (settlement) but in actuality gets extended far beyond in many instances in hope of yet higher short-term profitability. In the reality of naked shorting, covering a position has been functionally an “optional” undertaking.

The elimination of all short sales would add stability and support long term perspective to the market, restore some value to the rights of ownership, and remove some of the characteristics of “gambling” from what should remain the primary source of stable capitalization in a capitalist economy. Short sales are an implement of greed… the by-product of which is usually unnecessary fear.

It’s like buying a life insurance policy on someone you don’t even know… if they die, you don’t care… you simply profit!

Al Benelli, CFP Monday, April 6, 2009 at 11:21 AM PT

Jason, Everyone but you and those who agree with your are idiots :-) What a healthy point of view!

Al – interesting analogy!

Sramana Mitra Monday, April 6, 2009 at 1:00 PM PT

Perfect analogy Al.

DB Monday, April 6, 2009 at 4:41 PM PT

I remember when I first started investing, 30 years ago. Yes, I also hated the shorts, those who lived on destruction, and not creation. It seemed unnatural, morbid, and just plain twisted to live off of the decline of something. Parasites!

Then I grew up, and one day as I was CONSUMING something ELSE for LUNCH, realized it was no different than the rest of the universe, you might as well ban life, black holes, natural selection, thermodynamics, birth control, yin-yang, movie villains, etc, etc

Since that epiphany, I have never been a direct short, as I still never wish to be in a position where I can lose over 100% of my money, a risk the short takes (but few point out). However, I have had many short positions through PUT options, and my investments have been so much richer for it, and I UNDERSTAND why some go short. If someone sees a Company that is weak, why not take that side?

As far as abuses, they exist on both sides of the trade, long and short. I saw no source or logic in your Blog stating why abuses are only on the short side. In fact, over my many years of being in this game, one could argue that the long side is more corrupt, and always looking for a way to justify more of a cash infusion to support their habit (hey, am I the only one who remembers President Bush lobbying for Social Security to be released for general investment? Hmmmm, I wonder where that money would be today, in the hands of some evil shorts?). Enron, WorldCom, Bernie, were any of those spectacular collapses on the short side, or were they spewing long propaganda that all will be well, growth will always be forever, all that.

Your article is more emotion than rational fact about the way true markets work. Its always nice to have a simplistic world view, but next time you are chewing your food remember, there is no free lunch, someone/something further down the chain always gets the raw deal, and don’t feel too offended about the way things work in the real world.

Peace.

Rob Tuesday, April 7, 2009 at 1:23 AM PT

CFP and SM,
really, you need to read the academic research or even just take an economics or finance course at your local college. The secondary market — the stock market as you call it — does NOT create value. period.

Corporate financings, ie IPOs and debt issuance, arguably, creates value through leverage and expanded coporate operations. But, once those securities are out there, there’s no more economical value creation.

So, to use the Casino analogy that’s EXACTLY what the stock market is, if you’ve every bought a security or told someone to buy a security and said, “because it will go up”. Wrong — if securities are fairly priced (so that it’s not speculative) then all you should get from that security is its cash flows. As investors we HOPE the company’s future cash flows grow, and that it’s value will go up, but there’s no guarantee there. Read a prospectus.

Shorts don’t add volatility to the market, this is a fact, proved with evidence not supposition. Say it all you like, it’s just not true.

so, banning shorts and/or all derivatives is like trying to put pandora back in the box.

By the way, don’t post on HARO or Linkedin anymore that you want people to comment on this board. (cuz, although i DO have all the time in the world — i’m on severance — it’s just not worth trying to dialogue with people who comment “and all the idiots who agree with you”.

pesc Tuesday, April 7, 2009 at 5:55 AM PT

oh, i had one other comment.

“Independent Analysts” is EXACTLY what S&P, Moody’s, Fitch, AMBest, etal were supposed to be. And, look where that got us.

One of the basic America tenets is checks and balances… having analysts who get paid by companies to do analysis (because “independent” analysts gotta eat too) are then “checked” by the Wall Street analysts and all that is checked and balanced by people who are willing to put their money where their mouth is through derivatives and shorts. So, the system works (except in the case of fraud, where we already have laws against that.)

If you really want to suggest a solution, let’s establish a not-for-profit, paid by tax dollars, to have truly independent analystsn who certify and monitor every security traded to make sure it’s fairly priced. Then, Mom & Pop can buy the best companies of the US, as federally certified and guaranteed. Then if one of these companies (how do you spell GM?) goes down, the taxes will already be there to bail Mom out. And, of course, there won’t be a small or micro cap market, since those companies won’t get capital to innovate and thus won’t exist.

pesc Tuesday, April 7, 2009 at 6:07 AM PT

Okay, I have been called a lot of things, but simplistic is a new one …

Independent Analyst: Look at Bloomberg’s business model. About 175,000 finance professionals pay $1800 a month to subscribe to the high quality financial data and research Bloomberg produces. That’s a $300 million+ per month business. Don’t tell me that’s a non-profit.

Take that model and why not come up with an analyst firm that does just extremely high quality analysis? Not trading. Just analysis. Objective, investigative analysis.

In my assessment, if this class of analysts existed, both finance professionals and corporate America would be consuming their products, and they would have a thriving business. But it would be a business separate from the banks / traders.

As for the Casino analogy, I don’t have a problem with the fact that the market exists for buying and selling of stocks, because that IS an essential piece of Capitalism. But I don’t see, despite all the rants here, what is the specific purpose of short selling, besides the argument that short sellers are some of the best minds in the business, and they are really good at analyzing stocks.

Well, if that’s the value, I’d prefer that they work as analysts, not traders.

I am looking for Logic. I can’t find it in the above discussions. Please help me with logical arguments, rather than by calling me simplistic or emotional. I am neither.

Sramana Mitra Tuesday, April 7, 2009 at 10:32 AM PT

Sramana, I can appreciate that you would like to maintain a purely philosophical stance in this debate, but there is a practical element to the debate that is screaming out for attention.

Indeed, the entire debate falls into irrelevance unless those who argue in favor of banning short selling also argue in favor of abolishing put options. Human nature mandates that the fear of loss is a much more powerful motivator than the opportunity to gain. That fear is the very fuel that creates demand for put options — put premiums are paid by those who are afraid that the value of their stock might plummet.

Of course, “opportunity to gain” players also fuel demand for puts — they buy puts when they believe the underlying instrument will be losing value in the near term. Hey, wait a minute – that sounds an awful lot like short selling to me — Duh!

One of the bloggers in this thread, Al, has stated that:
While the same net effect of a short sale could be accomplished with the purchase of a “put” option, short sellers, driven by rapid profit desires, avoid the option premiums and the expiration dates by driving prices downward…”

Al, is there some great wisdom associated with having a chunk of margin tied up for a short sale vs. paying a relatively small put premium? I know quite a few very successful options traders who can provide tons of evidence to the contrary! And guess what, there is nothing sinister about being driven by “rapid profit desires” — just ask those same successful put buyers!

And while your comment about market makers who “watch short positions intently” is correct, it also correct that those same market makers watch put/call ratios intently. Your argument that there is some great difference between buying a put (one that’s next up on the calendar) and shorting the underlying stock — in terms of the downward price pressure on the underlying stock — well, that argument just doesn’t hold up.

Sramana, there is clearly no point in arguing in favor of abolishing short selling unless you are prepared to argue in favor of abolishing put options as well. If that is indeed where you are going with this, I would suggest that you have a chat with Warren Buffet before you go any further. Mr. Buffet does not buy a single share of stock without protection. If you take away his puts, he and countless others would shun the risk of total exposure in the naked buying of stocks. Does that fall into your vision of…. all the instruments necessary for a “market” to operate?

Rick Tuesday, April 7, 2009 at 11:29 AM PT

Rick, may be. I am still investigating. Just because Soros likes to do this and Buffet likes to do that, doesn’t mean that it is a good thing for the overall financial system of the world. They do it because they have mastered the utilization of the current financial instruments available to mankind.

So may be puts also need to be banned. I am working on getting experts on the subject.

Sramana Mitra Tuesday, April 7, 2009 at 12:19 PM PT

Financial markets exist to provide liquidity. One sells shares to raise capital and buys them with an expected return. If the company does not pay dividends, all the risk is on the buyer. This is just like a country club except I can claim interest in the asset (e.g., the golf course) if the club goes under.

When money is made by buying and selling of the asset without consideration to the utility of the asset, we have a problem The good news is more folks are realizing that “investing” is really a form of entertainment. The bad news is that there is expected monetary value from making an investment (vs. pure entertainment that just makes you feel something.)

One way to make this work is to use standard metrics to value current state to avoid analyst subjectivity. Valuation would then be based on projections of ROIC. Ultimately, the only claim an equity holder has is the residual cash after liquidation, which is a fairly simple thing to estimate. The more cash, the greater the value. Less cash means more faith (and higher risk.)

Basically a short seller is making a bet that the company will invest poorly or does not understand its markets. Why not take money from someone willing to bet against you (by going short?) If the valuation principles are clear, the bet is all about execution and the quality of an assessment of market opportunity.

JD Tuesday, April 7, 2009 at 2:00 PM PT

Yes, but why does the system need to offer people an instrument through which to make money based on the doom of other companies?

Help me understand how this helps achieve some objective, and what is that objective?

Sramana Mitra Tuesday, April 7, 2009 at 2:07 PM PT

Sramana, if Congress enacted legislation making it illegal for insurance companies to offer home insurance policies, what effect do you think that would have on the real estate market in the United States? What would happen to the mortgage industry? Even if we were to take mortgages out of the equation and assume for argument sake that everyone had enough money to pay cash for a house, would you buy a house without insurance and expose yourself to the risk of total loss via fire, flooding or some other disaster? Clearly no one in their right mind would ever consider doing such a thing today.

But many years ago people did buy houses without insurance, and there were so many catastrophic endings that people were AFRAID to buy homes, and mortgage lenders were AFRAID lend money with such great risk exposure. Needless to say, this situation was not a good thing for the economic health of the nation.

This fear of loss phenomenon created great demand for the insurance industry — as more and more underwriters entered the home insurance market, the increased supply of underwriters meeting the demand for home policies caused premiums to become more affordable — and affordable home insurance heated up the demand for homes. Needless to say, this was a good thing for the economic health of the nation.

Since put options are to the stock market what home insurance is to the housing market, I’m sure you can see that the options market performs a very important economic function. If that protective mechanism (put options) were to suddenly disappear, the end result would be catastrophic for the stock market and therefore catastrophic for the economy.

The fact that people also use put options as a speculative vehicle is a very good thing for the options market — without the liquidity provided by such market participants, the options market would be a stagnant pond incapable of sustaining life.

My point about the futility of banning short selling is that people would simply move over to put buying to accomplish the same thing. And since we need the puts for the health of the stock market itself, what would be accomplished by banning short selling in the first place?

Rick Tuesday, April 7, 2009 at 8:04 PM PT

Thanks for an interesting point of view on this issue. There’s another pretty compelling piece on short selling (with a great debate in the comments) here: http://www.huffingtonpost.com/amy-ephron/stop-the-short-sellers_b_180788.html

frannie Tuesday, April 7, 2009 at 8:15 PM PT

Because that’s how markets work. Prices reflect the subjective valuation of every individual assessing the investment. I don’t see why you should not be able to profit on a negative assessment, philosophically!

Sramana, what is your objective? Greater day to day stability? If you’re going long, it shouldn’t concern you, should it?

Let the folks playing the daily volatility of the markets pass money back and forth between themselves. If you’re investment is based on sound research, as you say, you shouldn’t worry about it. If you are a disciplined trader you will have made the right long term call and you will find the appropriate time to capitalize on your investment.

I thought the example of taking out a life insurance policy on a stranger fit very well.

Daniel Tuesday, April 7, 2009 at 8:27 PM PT

Daniel,

I am not looking at this from my personal benefits pov. Short-sellers have been destroying stocks, not giving companies a chance to stabilize, turnaround, etc. Individual investors get creamed when large hedge funds descend on a stock on its way down, driving it down further. All this goes to destroy value, and that has to be stopped.

I just don’t like a system that offers instruments and incentives to speculators to destroy value.

I am asking for your help in trying to stop that.

Sramana Mitra Tuesday, April 7, 2009 at 8:32 PM PT

Just a few questions on your short-selling views:

Will banning short-selling get rid of speculators? Or will they all retire and move to a remote island?

Did the short-sellers help or hurt speculators paying 100x’s earnings for tech stocks in the late 90s?

If companies are financially sound, then wouldn’t they want to purchase their own bargain priced shares that were artificially depressed by rogue short-sellers?

If ridding speculation is your goal, then is your next crusade prohibiting margin accounts? Or are you OK with the trillions of dollars in leveraged long hedge funds?

Should we also get rid of selling futures market short too? Or could this be a valuable tool for agriculture and commodity producers whose livelihoods depend on these hedging strategies?

Does banning short-selling and put options help or hurt retirees trying to insure (protect) their hard earned retirement nest eggs?

If independent analysis is what we need, then why did the mandatory government implemented independent research, post the Blodget/Grubman tech bubble burst fail?

Don’t we already have independent analysis in place? Oh yeah, they’re called buyers and sellers. Maybe people should be doing their own research or hire independent money managers that do their own independent analysis? Or here’s another one, maybe listening and following long term successful investors makes more sense (including those that short stocks)?

If a key goal in financial markets is to achieve accurate/efficient price levels, then does it make sense to ban a large group of participants that are investing their own dollars with the goal of accurate price-setting?

I appreciate the provocative debate, but is a populist witch hunt searching for a scape-goat (short-sellers) more a function of the times (severe bear market)? Where was the outrage regarding short-sellers when price levels were a 100% higher than they are today?

I have more questions regarding your viewpoint, but my fingers are getting tired.

Sincerely, Sidoxia

Sidoxia Tuesday, April 7, 2009 at 11:21 PM PT

Short sellers absolutely do create value, at least for their investors, and are not speculators. Unlike analysts, who have little incentive to take risks and stray from groupthink or consensus on a given company, short sellers have a profit motive in finding overvalued companies and shorting them. They take significant risk in doing so, and do not do this lightly.

The problem, then, is not short selling, but naked sort selling, which artificially boosts the supply of stock and forces the price down. Naked short selling is and has been illegal, but happens all the time. This points to an even more fundamental problem on Wall Street — not the lack of regulation, but the lack of enforcement. It is the naked short sellers, who can sell down even a good company with impunity, that are your value destroyers, but the regulators are either unable or unwilling to reign in this practice by enforcing the laws already on the books.

My personal interest is in precious metals, and this is a group of markets where naked short selling has been incredibly destructive and controversial. The weekly COT reports from the COMEX, and recent data from the Office of the Comptroller of the Currency show huge short positions in gold, but especially silver, which far exceed the amount of physical metal mined in human history. The large commercial banks and broker dealers artificially suppress the prices of these metals by flooding the futures markets with paper and settling contracts in cash. By altering their naked short position, these big players are able to directly manipulate the value of these commodities.

These, of course, are serious abuses of the free markets. Put options pale in comparison. The purchasing of a put option does not increase the supply of a stock and therefore does not directly drive down its price. When bought in large quantities, put options can have a psychological effect in the short term and trigger some real selling, but this is hardly the sort of permanent value destruction that demands full and immediate attention.

j Wednesday, April 8, 2009 at 12:39 AM PT

I think people are not directly answering Sramana’s question. I cannot promise to do that, but I will at least try.

Firstly, a disclosure. I am a short seller. I hardly ever go long. But I would like to.

So why does the world need short selling? Will this is my justification for it.

Capitalism is brutal, essentially a zero-sum game. There are those who participate in the system by choice and as their business (financial professionals) and those who participate because they are forced to and have no other savings options (e.g blue collar workers contributing to 401ks).

The thing is, the professionals roughly know what happens, they have the Bloomberg terminals, informal business networks, and access to corporate management, brokers etc. We should not care about them if they make or lose money (on either the long or the short side ) as they have all the resources available at their disposal.

But what about the blue-collar worker who does not have these resources, and is naively contributing to his 401k? No matter how smart he is, he will always be making sub-optimal investment decisions as he will never have as much information as the professionals. He might get lucky now and again, but that would be the exception.

So here is where the justification for the short-sellers come in. Say he wants to naively buy a blue-chip stock, like Citigroup. He doesn’t know much about it, but he assumes that he is fairly priced in the market. So he buys it close to the peak price, $50, as it had not really been shorted that much at that point in time. Well, now it’s just below $3, so he’s lost $47. What happened to this $47? It was not that the short sellers ‘stole’ this value from the naive investor. Short-sellers cannot affect value, only price. So if Citigroup is really cheap, after losing $47 it should be the bargain of the millenium, a generational buying opportunity! But investors are not really that keen. We can only surmise that Citigroup was never ever worth anything near $50, and $20 would probably have been a fairer price?

So thats why short selling is good. It helps the average man on the street. It keeps prices close the true value, so if he had bought Citigroup at $20 rather than $50, he would be far better off today. We cannot expect tradesmen, school teachers to know the true value of securities in the market. That is the job of investors, both on the long and the short side.

As a final word, we need MORE short sellers! imagine how much better off the average american consumer would have been if crude was shorted when it was above $100 per barrel? There is never ever a justification in preventing prices from reaching their true value. Preventing short-selling would do just that.

zdust Wednesday, April 8, 2009 at 12:51 AM PT

Rick, If the objective is insurance, then the service should be provided by an insurance company, no?

Sidoxia, My goal is not to rid speculators. My goal is to stop value destruction in the hands of the speculators. And my goal is to adjust compensation structures such that speculators don’t make exorbitant sums of money, so much so that value creators feel cheated. So, my goal is justice.

zdust – your logic, I must say, is the the illogical logic I have ever encountered. Blue Collar workers invest in their 401 (k)s through mutual funds. Mutual fund managers are supposed to manage the funds and are expected to be more sophisticated investors. The fact that most of them seem to be just as ignorant and incompetent as the rest is a different issue.

But I am coming back to the original point – there needs to be independent, objective analysts and media whose job is to report what is exactly going on at companies, and what the real value needs to be.

Analysts inside banks doesn’t work.

The tech bubble was created by analysts like Mary Meeker talking up stocks without any attention to fundamentals. The entire population behaved irrationally. Hopefully we have learned from that.

I am, overall, looking for a more rational, “real” system, rather than the house of cards – the unstable, unbalanced, fantasy system we have today. A system that has a convoluted and unfair reward structure.

Sramana Mitra Wednesday, April 8, 2009 at 8:57 AM PT

There is no question that the market gets maniputed. The behavior of certain stock prices make absolutely no sense until you figure out who did benefit from the stock movement. In the privat company world, a few shareholders sit down and “decide” what the stock value is. In the public market the game is much bigger. I actually think that short selling is a much worse offense than a lot of other activities that we now consider criminal!

Taher Elgamal Wednesday, April 8, 2009 at 9:18 AM PT

When people live their whole life on luxery which they haven’t earned yet on a different way speaking when people live their whole life repaying their loan and at times forced to take decisions which they wouldn’t have taken otherwise we say that’s not good.

Living a life by taking loans and buying things which is not earned ‘yet’ is not good as we all learned hard way and still reeling under it.

Similarly I guess selling something which is not owned would have similar impact on the individual as well as society.

Greg Wednesday, April 8, 2009 at 9:51 AM PT

Sramana, much of my thinking has been expressed in one form or another in prior posts, but perhaps would better satisfy your desire to see a more logical argument.

First, a few premises that I think we can all agree upon:

1) The goal of capitalism/free markets is to create value through the allocation of capital to those investments where the return (relative to the risk) is favorable.
2) Capitalism, and as a derivative, value creation, functions best in a stable economic environment (as opposed to one subject to bubbles and depressions).
3) In a market based on capitalism, there are always winners (those who create value) and losers (those who destroy value).

From the above premises, it follows that participants in capitalism/free markets are driven by profits, prefer a stable economic environment and the more “nimble” ones beat their competitors. Not yet relevant to the question posed, but important when making the following arguments.

1) The stock market is generally perceived as a free market, where buyers and sellers set the prices based on supply and demand.
2) Investors (buyers and sellers) are participants in the stock market.
3) The primary function of the stock market is to provide liquidity to investors.
4) Liquidity creates economic value because without the liquidity provided by markets, companies, consumers, etc. would not have access to as much capital and therefore could not seek to create as much return on capital.

From the above statements, I believe we can draw the conclusion that short-selling plays an important role in the proper functioning of the stock market. First, short-sellers are simply participants in the market, providing liquidity to buyers and as stated previously, liquidity creates value. As participants in the market, short-sellers are driven by a desire for profits at an acceptable level of risk. With the potential risk of infinity (there’s no limit on how high prices can go), rational short-sellers are unlikely to simply short everything and depend on the spread of rumors (false or otherwise) to make their return. Rather, it is more likely that a rational short-seller would target those companies with fundamental flaws in their businesses as this would mitigate risk and create a much bigger opportunity for profit. This to me is a value creating activity as it is a more “nimble” response to identifying value destroying entities and helps investors/lenders avoid funneling additional capital towards a broken entity at the expense of another company that could provide value creation. A market where short-selling was forbidden would not be nearly as nimble and as such, would likely result in a longer period of capital destruction. Without short-selling, the process of determining which entities are failing would take much longer and significantly slow the wheels of capitalism.

As for short-sellers simply being in an analytical role as opposed to profiting on the downside, I’m not sure why that would be a preferable solution. If an entity is going to fail anyway and the short analysts are pointing this out, no one profits when holders of the securities look to sell and realize there are no buyers. On the otherhand, if someone profits from the downside of a failure, those profits can be reinvested.

Kevin Wednesday, April 8, 2009 at 10:08 AM PT

By far the best argued response so far, Kevin. You are saying that short selling offers (a) liquidity (b) nimbleness to the market.

Sramana Mitra Wednesday, April 8, 2009 at 10:27 AM PT

This is simple. And you are just simply wrong. For short sellers to stay in business, they must be profitable. To be profitable in the stock market, you have to buy low and sell high. Amazingly that is exactly what good short sellers do, just in the reverse order. The only thing short sellers do to a market is add liquidity. It really is that simple. Everything else is in the imagination of the mob, something you are incorrectly helping to foment without any real life experience whatsoever.

john fichthorn Wednesday, April 8, 2009 at 5:21 PM PT

Sramana, the insurance company idea was an experiment that failed miserably — the underwriters were so spooked by crashes and so unable to properly analyze all of the factors necessary to write the risk that the whole idea just fell apart. So the answer to your question is no, and the answer to the problem is a vibrant and liquid options market, which, thank goodness, we have.

Rick Wednesday, April 8, 2009 at 6:26 PM PT

Without distinguishing legal short selling from naked short selling, this entire discussion is futile.

j Wednesday, April 8, 2009 at 8:07 PM PT

Looks like a few changes are already in evaluated by the SEC:
http://www.msnbc.msn.com/id/30107782/
http://www.nytimes.com/2009/04/06/business/06short.html

Most likely, the uptick rule will get reinstated.

“Another option floated by the SEC, besides reinstating the uptick rule, is a sort of “circuit breaker” for stock prices. That approach, in three variations, either bans short-selling outright for the rest of the trading session in a stock that declines 10 percent or more, or restricts short-selling of the stock for the rest of the session based on its previous sale price or highest bid.”

“At the same time, the Obama administration has proposed to Congress a sweeping overhaul of the nation’s financial rule book meant to prevent a repeat of the banking crisis that toppled iconic institutions and wiped out trillions of dollars in investor wealth. It includes requiring big hedge funds and other private pools of capital to register with the SEC and open their books to federal inspection. Credit default swaps also would come under federal regulation for the first time.”

Overall, my instinct is that a thorough investigation is long overdue. I am glad to see that it is happening.

Sramana Mitra Wednesday, April 8, 2009 at 8:31 PM PT

The Uptick rule that was in place kept the short sellers in check prior to 2007. That prevented people from shorting from a pure speculative point of view. I don’t think we can ever get rid of Greed from humans. Greenspan and everyone else always talked about market can regulate themselves without any intervention. One thing they could not model was human greed. We don’t need to get rid if shorting all together, we need to control it.

Ven Friday, April 10, 2009 at 6:04 AM PT

How about imposing a withholding tax on short sales (so the sale price is taxes as a gain immediately), which is refunded when covered based upon the net gain or loss?
This will discourage wild speculation, and make it harder to profit from spreading panic or other illegal actions.
Combine that with forcing companies to deliver shares; Failures To Deliver should enable the defrauded buyer to send a collection agency over to the shortseller to seize assets. There is no excuse for Failures to Deliver.

Steve Friday, April 10, 2009 at 9:20 AM PT

Hp Michelet emailed me privately:
Sramana – my short comment is that we need the short sellers – can the rules be different? Probably – by reinstating the “up-tick” rule. In my mind the short sellers provide a necessary element of liquidity to the market place. Now that all of the banks are reducing their proprietary trading positions, the short sellers are needed more than ever. HP

Looks like 2 consistent themes have emerged here: (a) reinstate the up-tick rule (b) short-sellers are necessary to provide liquidity to the market.

Sramana Mitra Tuesday, April 21, 2009 at 10:58 AM PT

The problem isn’t short selling, it’s short anything when dealing with the equities market. The equities market is, or should be, a place where money is invested for a long term gain. All of these short term strategies, program trading, short selling, stock futures trading and the like, prey upon the long term investor and a means needs to be found to curtail the parasitic use of these instruments. At least that’s how it looks to one index fund investor.

Thomas Fiore Wednesday, April 22, 2009 at 3:46 PM PT

In my assessment, if this class of analysts existed, both finance professionals and corporate America would be consuming their products, and they would have a thriving business. But it would be a business separate from the banks / traders.
_______________________________________________________
andrew001

Stock Value

andrew001 Friday, August 6, 2010 at 3:01 AM PT

I am most of all in agreement with Jason's point above: there needs to be a class of analysts whose job is to do investigative research and offer both sides of the issues in companies.

And these need to be people without a trading position in the stocks they cover, so that no conflict of interest exists. This means, these analysts should not be sitting inside banks that are also trading the same stocks.

They need to be truly independent entities, and adequately compensated to be so.

detectivi Thursday, September 9, 2010 at 12:23 AM PT

Hi Sramana – Short selling puzzled me for a long time. The underlying mechanism of a short sale is the borrowing of the security from an institution that's currently holding that security as a long-term investment. Short selling would be 'magical' if not for this underlying transaction. What always confused me is why institutional holders allow this form of borrowing or even want to lend out the securities they're holding 'long'. It actually adds a ton of value, and hopefully I can explain that here.

The rest of my rather lengthy response is available here: http://www.selfreliantllc.com/wordpress/?p=109

Alex Kaufman Sunday, July 10, 2011 at 5:26 PM PT
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