The Rude Awakening
Laguna Beach, California
Monday, March 5, 2007 ------------------------------ - Knowing what NOT to invest in,
- When information is the scarcest good of all,
- Scorn, abuse, subpoenas and other rude issues…
------------------------------ Eric Fry, reporting from Laguna Beach, California… Short sellers make money when share prices fall. That's the main reason why they attract Wall Street's scorn…and abuse…and subpoenas. But short sellers also provide a very valuable benefit to the entire community of investors: they promote the discovery of truth, even when the truth might not be very pleasant. ---- Options Trading Invitation For Rude Readers ---- Our readers could have turned $5000 into $1 million in just over 5 years "Each week, I tell my readers to make just 1 investment buy. And last year, not one pick
lost value! Just 2 in 2004, 4 in 2003! It's no wonder our readers could have turned $5,000
into $1 million in just over 5 years! Read on here to find out how !" - Steve Sarnoff, editor,
Options Hotline. ----------------------------------------------------------------- Don't Sell Short Selling Short
By Gary Galles [Publisher's Note: Today's column appears courtesy of the Ludwig von Mises Institute] Stockholders and managers of firms, whose interests lie in higher prices for what they own or manage, miss few opportunities to deride short sellers. As Holman Jenkins of the Wall Street Journal put it, "short selling is a business widely unpopular with everyone who has a stake in seeing stock prices go up." Regulators, whose blunders short sellers frequently reveal by discovering fraud that escaped their attention, respond similarly. That combination of interests helps explain why, at various times, short selling has been banned in many countries, including England, France and Japan. Such views are reinforced by accusations that short sellers hope for bad things to happen. Others misplace the blame for the association between short selling and falling stock prices, especially in a "crisis." False comparisons, such as holding short sellers to a standard of perfect foresight, are also used to attack them. However, all of these attacks are misguided. Short selling is part of the information-revealing process that Mises, Hayek, and others emphasized as the central aspect and advantage of the market process. In a world of uncertainty and change, information is the scarcest good, and short selling is an important source of additional information that would otherwise be lost. Allowing short selling increases the number of people with an incentive to discover valuable information about firms' prospects, by providing an added mechanism to benefit from information that turns out to be negative. Negative information may not be as valuable as positive information for purposes of cheerleading, but it is much more valuable for avoiding costly errors. Much of successful investing relies upon negative information - knowing some things not to do, rather than knowing what to do. To attack or restrict short selling is then to restrict the market's ability to elicit and integrate all available information. Restrictions on short selling are analogous to a voting process where there are only the possibilities of voting yes (owning shares) or abstaining from voting (current non-owners), but "no" votes (selling what you do not own) are impossible. Short sellers have been portrayed as heartless opportunists, benefiting from bad outcomes. But they are no different than doctors who profit from illnesses, or teachers who profit from ignorance, or locksmiths who profit from thievery. Further, revealing mistakes is a valuable component of an efficient financial market, and a far cry from just hoping for bad outcomes (just as parenting sometimes involves deflating children's false hopes, not to harm them, but to help them make better choices). What is called short selling in the stock market is a common risk-management process in all sorts of businesses. A farmer who sells on a futures market when he plants, before he has produced his output, does the same thing. And this process is hardly new. As the 1909 New York State Commission on Speculation noted, "Contracts and agreements to sell, and deliver in the future, property which one does not possess at the time of the contract, are common in all kinds of business." There is no reason why a practice commonly accepted in business is somehow harmful to those participating in the stock market. Regulatory opposition, ironically, also indicates the positive consequences of allowing short selling. Regulatory agencies are supposed to prevent fraud, questionable accounting, and other management misbehavior. However, they often fail not only to prevent, but even to detect them. Short sellers who are betting their own money on being correct often uncover what regulators miss, as they did at Worldcom, Enron, Tyco, etc., showing themselves as more effective market policemen than the official regulators. Opposition to short selling also confuses correlation with causation. A short seller's negative assessment does not cause a negative outcome. The future will be what it will be, no matter what the short sellers expect. Selling short cannot force a stock's price down for long, if the fundamental circumstances do not justify it. Short sellers simply recognize negative information sooner. Their activity can begin the process of reducing market prices, but it is the negative information that causes stock prices to fall. Opposition to short selling, therefore, is often no more than objecting to its effects on a particular stock the opponent currently owns. Short sellers are also attacked for allegedly spreading negative rumors that sometimes turn out to be false. But false positive rumors are regularly asserted by a far larger group who benefit by pumping up stock prices, from corporate managers to brokers to financial talk show touts. In addition, the consequences of all forms of potential misinformation are made more problematic by the belief that regulatory agencies actually protect investors from it, when they really don't. Short sellers are also criticized whenever they are wrong. But holding them to a standard of correct expectations is an impossible standard. No one has perfect foresight. People who buy stock are not always correct that it will go up thereafter. And even if they were, those who sold the stock to them would have to have been wrong in their judgment. Applying such a standard of perfection to short sellers alone is just a mechanism to attack them, not a serious idea. Firms do not always stop their aversion to short sellers at negative attitudes. They often directly attack them. For instance, The Economist reported, "Not long before Tyco went bankrupt it was still buying full-page advertisements to campaign against short-selling." Similarly, within a month of Biovail filing suit against short sellers for expressing negative opinions about it, the SEC announced an investigation which led to a settlement involving serious fraud charges. Perhaps most telling about the assaults on short selling is a 2004 NBER study that discussed the fact that "Firms use a variety of methods to impede short selling, including legal threats, investigations, lawsuits, and various technical actions." It revealed the high probability that firms attacking short sellers actually have something to hide, indicated by the fact that "firms taking anti-shorting actions have in the subsequent year very low abnormal returns of about -2 percent per month." Short sellers receive widespread condemnation. But it is undeserved. They are no more self-interested than others in financial markets. They provide a valuable counter-balance to the barrage of hype and misinformation that issues from Wall Street and corporate boardrooms on a daily basis. Maybe it is time to stop selling short selling short --------------------------------- As always, you can send any comments you have on the above article to us here. | 
