The Virtues of Short-Selling

Is there anything that rankles populists who are "anti-speculator" more than the ability to short stocks?  From time to time countries that are upset about falling markets will ban short-selling.  But I have defended stock (and other asset shorting) as a critical market mechanism that helps to limit damaging bubbles.  I wrote waaaaaay back in 2008, after the US temporarily banned short selling of certain assets:

At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements.  For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset.  They start buying the asset, and the price starts rising.  As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers.  The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more.

Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios.  The ownership base for the asset is now disproportionately
made up of those sky-is-the-limit bulls, while everyone who thought these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued.  But how does it come to earth?  After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so.  As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.

Thus, we have short-selling.  Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote [on] the value of the company.  Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.

I am remembering this old post because Arnold Kling links an interesting bit on economists discussing the Big Short, who among a number of interesting things say this:

Shorting the market in the way they did is very risky, and one has to be very confident, perhaps overconfident, in one’s forecast to take such risks. As a consequence, many people who were pessimistic about the housing market simply stayed on the sidelines—which in turn meant that for a while, valuations in the market primarily reflected the beliefs of optimists.

The timing issue is key.  I have been right probably in 4 of out the 5 major market shorting opportunities I have identified in the last 10 years, but have been on average 2 years early with all of them, meaning I lost money on most of them, or made money after enduring some really big paper losses for a while.

  • Robert Rounthwaite

    Those who hold stocks are always that fraction of the market that values them most highly.

  • Shane

    I disagree completely with the premise of the quoted. Shorting will not start to bring the bubble down. That is not how it happens. For the price to rise new blood must constantly be introduced in the form of buy orders. The only worthwhile volume is an indication of is tops and bottoms. At the "top" volume slows down ... WAYYY down. No buyers means supply and demand has shifted away from buyers. New buyers can be more choosy as those that want to get out become larger in number. The bubble comes down slowly at first as there are really no new buyers, but everyone thinks that this rocket is headed to the moon so there are really no sellers. As the buyers at the top sit on their dead money they start to get more anxious because their lottery ticket isn't paying out. Then the swing starts to move to sellers. As dead money becomes losing money the price starts to drift down faster trying to find buyers. There is no volume here. The price keeps going faster and faster until all of the "weak hands" are out and the bargain bin becomes too tempting for buyers. At which point they start to enter heavily and buy out the panicked hands of the next big thing crowd. Volume blooms.

    Short selling gives a way for some to buy as a way to CLOSE a position. This effect allows buy orders to enter the market without a great regard to where the stock is going next. This is important when the market is moving big and fast. Those that are OPENING buy positions are very nervous because they are initiating risk and are left to the future risk of the market. Short Sellers are closing positions which means they are ending future risk. Those short selling buy orders (closing positions) are usually the first intrepid buyers in the market, making a base for buyers to start initiating positions. Without short selling there would be less volume on downturns and FAR greater volatility.

  • jdgalt

    Most people can't sell short anyway. Under the Securities Exchange Act of 1934, you have to have a margin account to do it, and you can't open a margin account unless you can begin by depositing $200k with your broker.

  • Shane

    $25k for a margin account, that provides day trading power of 4x. Honestly I have seen some brokers provide margin on $5k. And though options don't per se hit the market like short sells they do indeed affect it, and those can be had for as little as $500.

  • bigmaq1980

    Wanted to hedge my house back in 2005/6. Didn't for a variety of reasons - just "intuitively knowing" the rapid price increases were "not right" was not enough. Didn't want to possibly lose out on gains either, since the timing was completely unknown.

    Similarly, many market prognosticators, having been blindsided in 2008, have been predicting a huge "market correction" is just around the corner ... since, at least, 2011. Again, the fundamentals suggest that the increase is not justified.

    Shorting would have been a huge money loser over the last five years. Investing in gold would have been only a ~20% loss.

    Yes, you have to be uber confident... and, LUCKY, as it requires timing that NOBODY can predict.

    Guessing right, is called "foresight" after the fact and is celebrated. Guessing wrong is never remembered.

    Wonder where the contrarian big winners of the housing/mortgage debacle are today wrt investments, and how have they fared since that win.

  • Shane

    The article was about short selling ... not about speculation. You can lose big on long speculative positions just as easy as you can lose big on short sold positions. Short selling is a speculative tool to balance out the lopsidedness of long only markets.