Short Sellers Are People, Too!
Holman Jenkins, Wall Street Journal, January 29, 2003
"Short people got no reason to live," sang Randy Newman, reflecting a view commonly held by investors.
Make no mistake. Recent talk of investigating the hedge fund industry leaking out of the Securities and Exchange Commission and New York Attorney General Eliot Spitzer's office arises not because hedge funds buy and sell stocks and engage in other wholesome speculative behavior. It arises because, unlike most mutual and pension funds and legions of small investors, they also engage in "shorting" stocks -- i.e., borrowing and selling shares on the anti-social bet they can be bought back later at a cheaper price.
Short-selling is a business enormously unpopular with everyone who has a stake in seeing stock prices go up -- not least because of the suspicion that short sellers are engaged in the business of self-fulfilling prophecy.
Last year, the two biggest Dutch pension funds unilaterally announced they would no longer be making shares from their vast portfolios available to short sellers, whom they accused of being the source of unhealthy "volatility" in stock prices. Readers who keep a cross-referenced scrapbook of this column will also recall our account of Allied Capital, a company beset by shorts early last year. Allied's complaints are now a subject of investigation by Mr. Spitzer, and no wonder, given the man's unfailing divining rod for a hot issue.
Hedge funds have tripled in number over the past decade, reaching 6,000 at last count. Their assets have grown to $600 billion from $67 billion. That's a lot of money theoretically available to short stocks if the mood strikes. And brokerage houses have fallen over themselves in the past two years to make the short-seller's job easier, creating electronic networks that take much of the manual dialing out of the hunt for stocks to borrow and sell.
The California Public Employees Retirement System, one of the planet's biggest warehousers of stocks, has even gone so far as to set up an exclusive network for lending shares from its portfolio to makers of bearish bets. In short, we are likely to get a lot more short selling.
Before throwing ourselves off a bridge, however, it's worth noting the economics profession's view of short selling: that there's not nearly enough of it.
An article of the economist's faith is that there should be no limit to the willingness of informed investors to take money from the uninformed. That's the theory, but those who prize rationality in the marketplace like to treat making a negative bet on a stock as if it's as easy as making a positive bet. It's not.
Short sellers face all kinds of unique costs and risks. They have to track down shares to borrow, which can be peculiarly difficult in a bubble market. They have to pay interest on their borrowings. If the target rises instead of falling, they have to cough up more and more collateral. As a final kick in the head, at any moment a lender can yank his shares back if, say, he wants to sell them himself into a rising market. A short seller can be forced to liquidate his promising bet at the moment of maximum vulnerability.
In 1977, economist Edward Miller published a famous paper suggesting that when a wide divergence of opinion about a stock exists, the costs and risks of short selling can become so great that negative opinion will be driven to the sidelines. Others pushed the reasoning further, concluding that in such circumstances the most bullish investor sets the price. Is that what happened in the dot-com bubble, inquiring economists have wanted to know?
Studies are just beginning to pile up but the answer increasingly appears to be "yes." One of the easiest to appreciate concerns Palm, maker of the handheld computer of the same name. Palm started life as a division of 3Com. In early 2000, 3Com sold a 5% stake in Palm to the public, promising to float the rest before the year was up.
The publicly traded part of Palm immediately surged to a market value of $2.6 billion, while 3Com -- which still owned 95% of Palm -- actually fell. At one point, if you subtracted the market value of its remaining Palm stake, 3Com was actually selling for a negative $22 billion.
In a world adhering to the purities of the rational-markets faith, arbitrageurs should have instantly eliminated this discrepancy by simultaneously buying 3Com and selling Palm short, making themselves a mint. Yet the condition persisted for months because shorts couldn't get their hands on enough borrowed shares to soak up the nutty money and drive the price back down.
Here you had a seemingly unimpeachable case of the same asset selling for two different prices because trading in one, the Palm shares, was dominated by irrational punters. What's more, economists Owen Lamont and Richard Thaler, who studied the Palm case, found five lesser-known examples of the same anomaly between April 1996 and August 2000.
We won't tax the reader by reciting more studies, but let's pay tribute to economists who've been mining this vein of late, including Christopher Geczy, David Musto, Adam Reed, Darrell Duffie, Richard Ofek and others. Stock prices, after all, are important information, and when the information is wrong it can have serious consequences. Harry Hong and Jeremy Stein, for instance, point out that uneven participation of pessimists and optimists in the market may explain why stock markets sometimes "melt down" but never "melt up."
In the end, a kind of short selling did pop the bubble. Venture capitalists and investment bankers kept minting new dot-coms until they had soaked up all the fatuous money investors were willing to throw at them. Unfortunately there can also be bubbles in uninformed policy notions, such as the voices now battering Alan Greenspan for not using the heavy bludgeon of monetary policy to stop credulous investors from bidding up dot-com shares, even at the cost of bashing the rest of the economy too.
If that's the choice, give us more short selling any day.