Are Short-Sellers Really the Bad Guys?
by Joseph Engelberg, Faculty
With crises come blame, and following the 2008 financial crisis, there has been plenty of blame laid at the feet of short-sellers. It did not take long for regulators to pass judgment on these traders. In the midst of the crisis, short-selling bans were implemented in the U.S., the U.K., Japan, Canada, Spain, Australia, France, Germany, Italy, Belgium, Greece, Ireland, the Netherlands, and South Korea. And around the world, the heavy scrutiny continues to this day.
What is it about short-selling that attracts that level of condemnation? For starters, a short-seller in the stock market sells something he does not own. He does so by borrowing a share from a third party and selling it to a willing buyer. If the share price declines, he can buy back the share and return it to the lending party. If the short-seller sells at $15 and buys back at $10, then he makes a profit of $5 (less any transaction or borrowing fees). The bottom line is short-sellers profit when stock prices decline - a simple fact that has led to a lot of trouble for them.
Ask your grandmother what she thinks about a person who profits from someone else's failure. Chances are, she will not think highly of him. By betting against companies, short-sellers are often labeled as unethical and un-American.1 In "The Bear Book," John Rothchild writes, "Known short-sellers suffer the same reputation as the detested bat. They are reviled as odious pests, smudges on Wall Street, pecuniary vampires."
A short-seller's most vocal opponents are the CEOs of companies that he bets against, and it's easy to see why. Stock prices reflect the views of those who trade. If a trader has positive views about a company, he will buy shares of its stock and push up its price. Traders with negative views sell and push down prices. So you can think of a stock price as being set by the weighted average of traders' positive and negative views.
This is why restrictions on short-sellers - who have negative views - often lead to higher stock prices, which CEOs like. According to a recent study,2 CEOs have tried a variety of tactics to oppose short-sellers, including asking shareholders to withdraw their shares from the lending market, hiring private investigators to investigate short-sellers, and hurling insults. During a long-standing battle with short-sellers, Overstock.com CEO Patrick Byrne once called a short-seller who bet against his firm a "Sith Lord" and "a master criminal."3
When anti-shorting sentiment becomes strong enough, it makes its way to politicians and regulators, as in the case of the recent crisis. In the 1980s, a wave of anti-shorting sentiment led Congress to hold hearings about the practice. During those hearings future Speaker of the House Dennis Hastert described the practice as "the most blatant thuggery we've had come before this committee in a long time." As evidence of the damage done by these traders, officers from three firms that were targeted by short-sellers testified about their experiences at the hearing. Ironically, two of the three firms' presidents were charged with fraud by the Securities and Exchange Commission.
Despite the bluster about short-selling and the actions by some regulators, academics have long thought about whether short-selling should be prevented. As a logical matter, disallowing the negative information that short-sellers have from entering prices is not good for an economy. As an illustration, think about a company with a new technology and a share price of $100. Suppose there are smart traders who know that the new technology is worthless and that the share price should be $0. In a well-functioning market, these traders will short-sell the company's stock and push its price toward zero.
These traders incorporate their information by trading; without them, the share price may stay at $100. Now imagine that the company issues a million new shares in order to expand its business. Because the share price is currently $100, new shareholders will pay $100 x 1 million = $100 million for these shares. In short, the economy has allocated $100 million in resources to a technology that is worthless. If prices were correct, this misallocation of resources would not have happened. Because short-sellers help keep prices correct, they effectively help allocate resources properly in an economy. More generally, short-sellers who sniff out wasteful managers, inferior technologies, ineffective drugs, and fraudulent accounting reduce our economy's allocation to these duds and save it for worthier endeavors.
Those who want short-selling curtailed argue that short-sellers should not be able to spread panic and false rumors about a firm and profit from this activity. On this point, there is no argument. Spreading false rumors that affect stock prices is - and should be - illegal. A short-seller who fraudulently spreads false negative news about a firm is just as pernicious as a buyer who spreads false positive rumors about a firm. Fraud is the problem - not short-selling.
Academic researchers have examined data on short-selling for decades, and there is little evidence that short-sellers fit the stereotype presented by their opponents. For example, several academic studies have found that when there is a large amount of short-selling activity in a firm's stock, that firm's stock returns and earnings are predictably low in the future.4,5,6 In a study with colleagues at the University of North Carolina at Chapel Hill and Washington University, St. Louis, I found that short-sellers make extremely profitable trades on a firm's stock soon after public news is announced for that firm,7 which suggests that short-sellers are particularly good at figuring out what new information means for prices.
Recently academics have studied many of the countries that banned short-selling during the financial crisis and found that the ban had a detrimental effect on the liquidity and informativeness of banned stocks.8 Taken together these studies paint a picture of short-sellers as skilled information processors and that when we prevent them from participating in markets, those markets can become less liquid and prices in those markets can contain less information. These facts should give regulators pause about indulging in short-selling stereotypes when setting policy.
Joseph Engelberg is an assistant professor of finance at the Rady School of Management. His research focuses on the way information is disseminated among market participants, especially by financial media and social networks.
- The Economist. "UnAmerican activities." October 4, 2001. http://www.economist.com/node/808860.
- Lamont, O. 2012. "Go Down Fighting: Short Sellers vs. Firms." Review of Asset Pricing Studies 2: 1-30.
- McLean, Bethany. 2005. "Phantom Menace." Fortune Magazine, November 14. http://money.cnn.com/magazines/fortune/fortune_archive/2005/11/14/8360711/.
- Senchack, A., Starks, L. 1993. "Short-sale restrictions and market reaction to short-interest announcements." Journal of Financial and Quantitative Analysis 28: 177-194.
- Asquith, P., Pathak, P., Ritter, J. 2005. "Short interest, institutional ownership, and stock returns." Journal of Financial Economics 78: 243-276.
- Boehmer, E., Jones, C., Zhang, X. 2008. "Which shorts are informed?" Journal of Finance 63: 491-527.
- Engelberg, J., Reed, A., Ringgenberg, M. 2012. "How are shorts informed? Short sellers, news, and information processing." Journal of Financial Economics 105: 260-278.
- Beber, A., Pagano, M. 2012. "Short-Selling Bans Around the World: Evidence from the 2007–09 Crisis." Journal of Finance.