We are developing the social individualist meta-context for the future. From the very serious to the extremely frivolous... lets see what is on the mind of the Samizdata people.

Samizdata, derived from Samizdat /n. - a system of clandestine publication of banned literature in the USSR [Russ.,= self-publishing house]

More on that issue of profiting from when a company’s share price goes down

“If it [naked short selling] lowers share prices, that is because companies were overvalued. If the companies get into trouble as a consequence, that is because they were bad companies, not good ones. Bad companies deserve to be punished for being bad companies, so that capital can be better allocated elsewhere. (And yes, I am talking about the benefits of making it easy to take short positions *in general* rather than talking about the naked/covered distinction, which is a technical issue that I don’t actually think matters much. It may actually be better to discourage this and instead encourage people to take short positions via derivatives markets, which they can easily do). The truth is that we have had massive capital misallocation in recent decades. Capital has been far too cheap, and much investment has gone to all kinds of stupid places where it cannot generate a genuine economic return. Many companies have believed that they were good companies when in fact all they were doing was milking the fact that they had an unrealistically cheap cost of capital. For the last five years or so, this state of affairs has been ending, which is horribly painful. It would be over quickly if more people (politician, homeowners, and stakeholders in companies doing useless thing) would actually get it into their stupid heads that it has to end.”

Our own Michael Jennings, whose comment on my post of yesterday was too good to leave in the associated thread. I suspect this DVD, The Wall Street Conspiracy, will soon be heading for the trash can. I am wary of any “documentary” that starts from the premise that people in financial markets are like Bond villains destroying profitable firms in ways that make no sense even for the supposed “villains” in the case. For me, the key issue is transparency: if you are shorting a stock in a firm or whatever, and your counterparty is fully consenting to the transaction and you both understand the risks and don’t expect to get bailed out, then such activity should be put in the same category, IMHO, as off-piste skiing – risky but not criminal and certainly not fraudulent.

20 comments to More on that issue of profiting from when a company’s share price goes down

  • Jaded Voluntaryist (formerly Libertarian)

    The only real “Wall Street Conspiracy” I ever gave credence to was the “Business Plot” where some financiers in the 1930’s apparently gave serious thought to arranging a military coup in the United States. Some say it was a myth, but given what FDR was up to it wouldn’t surprise me 😉 Everything else blamed on a “conspiracy” is primarily self interest and not nearly as organised as people would like to imagine.

    As to the regulation of the markets, I’m afraid I don’t understand macroeconomics. What I do understand is that any complex system naturally gravitates toward a state of equilibrium and stability.

    The government’s constant gerrymandering of the economy equates to induced disequilibrium, which ultimately produces poverty, loss, misery on the one hand and cartelisation, greed and corruption on the other.

    All of the failings attributed to a “free” market are the direct result of a managed economy.

  • Paul Marks

    Jaded Voluntaryist.

    The key witness in the “business plot” was General Butler (ex Commandant of the Marine Corps). He claimed that various businessmen approached him to be a dicator when they had overthrown Roosevelt.

    As, for years before this time, this General was known for his denouncing of American business (especially in the context of Latin American) and his active cooperation with far left groups and indivduals – he would have been about the worst possible choice for such a role.

    A more antibusiness military dictator would be hard to pick.

    By the way he also said the businessmen were trying to create “Fascism” – a rather odd goal considering that “FDR” was doing that himself, as (for example) the National Industrial Recovery Act (and the rest of the “New Deal”) was directly made in imitation of Fascist Italy.

    Now to turn to your own post.

    You say “macroeconomics” – I assume that is a typo for “microeconomics”.

    No harm done – I make typeing mistakes myself (all to often).

    The regulation of the stock market, and other specific markets, is a matter of microeconomics.

    Actually establishment business interests love things like “bans on short selling” – because it means that the blunders of corporate managers can, for awhile, be covered up.

    A shortseller is a like a canary in a coal mine.

    He or she does not produce the poison – the activity of the short seller draws the attention of the public to what has been done by others.

    Short selling exposes the rotteness – drags it into the light.

    No wonder establishment interests hate it so much.

    Short selling does what government regulation is supposed to do (and does not do).

    It is classic example of voluntarism.

    By the way – if you want a real “business plot….”

    W.R. Hurst produced a film in 1932 called “Gabriel Flew Over the Whitehouse”.

    It is a classic defence of arbitrary power – of dictatorship and murder.

    See (for example) J. Goldberg’s accout of the film in his book “Liberal Fascism”.

    Hurst worked very hard to make sure to make sure Roosevelt was the Democrat candidate in 1932.

    “Paul, that is guilt by association – no wonder you are a Joe McCarthy and Glenn Beck fan….”

    Errrr a little problem with that…

    You see there is was a script consultant for the film (a consultant who really loved the film – loved it as much as his mentor Woodrow Wilson had loved the KKK pic “Birth of Nation”).

    The name of the script consultant?

    F.D. Roosevelt.

  • RRS

    M J is right on track to identify the core issue of value when stating that intrinsic values are not destroyed by trading methodologies.

    The core issue, that of the use of capital, is the critical consideration.

    Since 1965 (in the U S, I don’t know of U K comparables), the rate of return on capital had declined 25% by 2010, and is today at an estimated 1.6% down from about 6.5% in 1965.

    The trading markets are fixated on “earnings,” and there has been inadequate attention to the re-deployment of those earnings (accruing to surpluses).

    This is in large part from the problems generated by the motivations of managers in managerial capitalism, which has been the outgrowth of fragmented ownership of productive enterprises. Recognition of these trends goes back as far as Berle & Means (1933)[see, Adolf A Berle]; actually, more than 80 years. That set of “causes” differs from those Michael suggests, but holds true through periods of greater “capital constraints.”

    Intrinsic values, rather than trading market prices, of productive enterprises are reflected in the “productivity” of the assets of the enterprise. You don’t have to go to Omaha to learn that.

    Still, the trading markets are at issue in this thread. The various trading methodologies create opportunities for the “re-pricing” of the values of underlying productive assets in enterprises of fragmented ownership. The distinctions become notable in the analyses of private equity firms, such as Blackstone, et al.

  • H man

    My issue with short selling isn’t the betting on the price. I believe the short sellers serve a useful purpose. And it’s not advanced payment on goods either.

    My problem is with the stock ownership. The broker shouldn’t have the ability to profit from stocks in their care but not under their ownership. If a short seller would to come to me and ask to sell my shares in return for a premium I would refuse as I would not want him to short my shares. Why should the broker be able to do so with my shares?

    If I were a buyer of stock and a short seller were to offer me shares in the future I would either buy the shares outright from someone who has them or buy a call option which serves the same purpose from the point of view of the buyer.

  • Laird

    A fine comment, to be sure, but I thought MJ’s earlier post in that thread was even better. “Markets in which it is easier to take long positions than short positions can lead to mispricing, as people who think that the market is overvalued find more obstacles to making money if they are right than those who think it is undervalued. Therefore, markets in which short selling is difficult are more prone to bubbles than markets in which it is easy.” That cuts to the core of it.

    Still, H man makes an interesting point which I hadn’t really thought about before. Certainly if I own a stock it’s because I think it’s going to increase in value. Why would I want to facilitate someone else’s market actions which only serve to depress its price? (An increase in the trading volume caused by the sale of borrowed shares can only have that effect, even if it’s just in the short run.) Certainly I should be paid for the use of my shares, not the broker. I have done something like that in the past, selling covered call options. Why should the borrowing of my shares for a short sale be any different? Why doesn’t the actual owner get the premium? I suppose the simple answer is that the shares are held in “street name”, so it can’t be shown that any specific individual’s shares were the ones borrowed. But that’s not really a satisfactory answer; the premium could be allocated proportionately among
    all the broker’s customers holding that particular stock. Certainly it’s not a justification for the broker keeping that “found money”.

    And H man is also correct that most of the purposes of short selling can be achieved via the use of puts and calls (which also eliminates the problem of covering the cost when a stock goes “ex dividend”.) I understand the need for short sales in a stock which does not have listed options, and I suppose that if one wants to take a very long-term negative position (beyond the expiration date of the longest options) only a short sale will do, but except for those rather unusual circumstances is there really much of a need for short selling these days?

  • Richard Thomas

    In my mind, a big issue is the move away from companies providing dividends to their shareholders. This removes one of the most important signals as to the value of a company and makes the company a “black box”, forcing the market to guess the value and requiring all sorts of semi-effective and expensive regulating and reporting mechanisms. It also causes companies to be forced to bloat way beyond what is sane and sensible and possible to keep reasonable control of (both internally and externally).

    I’ve heard explanations as to why things are done this way (usually because of government interference) but that doesn’t absolve the issue at hand.

  • Jaded Voluntaryist (formerly Libertarian)

    RRS, correct me if I’m wrong (it’s not my field at all) but I was given to understand that macroeconomics refers to the management of entire economies, whereas microeconomics refers to the conduct of individual corporations.

    If that is a correct definition then I did indeed mean macro and not micro. I take issue with the hubris of governments believing they have the wisdom to tell the economy how it should be without causing chaos.

    As to the short selling, I don’t much care about it either way. I find it a bit unseemly myself, essentially betting someone is going to fail. I see no reason why it should be illegal though.

    But the economy in Britain and the US is a funny thing these days. Risk has been massively incentivised because whenever you really screw up, the government steps in and bails you out. This has created a situation which I believe to be unprecedented in human history.

    I mean, if that is the government’s attitude why don’t they just take the national budget for the next year to Vegas for the weekend? Who knows, they might just strike it rich…..

  • RRS

    Jaded –

    You may have tapped the wrong chap for your query, I don’t think it’s an issue of “management” (unless you have become so jaded as to be Socialist :-)), so here is a disinterested answer; hopefully not too much 3d party for this purpose.

    Investopedia explains ‘Macroeconomics’
    Macroeconomics is focused on the movement and trends in the economy as a whole, while in microeconomics the focus is placed on factors that affect the decisions made by firms and individuals. The factors that are studied by macro and micro will often influence each other, such as the current level of unemployment in the economy as a whole will affect the supply of workers which an oil company can hire from, for example.

    Read more: http://www.investopedia.com/terms/m/macroeconomics.asp#ixzz1phcR5fJN

    Definition of ‘Microeconomics’
    The branch of economics that analyzes the market behavior of individual consumers and firms in an attempt to understand the decision-making process of firms and households. It is concerned with the interaction between individual buyers and sellers and the factors that influence the choices made by buyers and sellers. In particular, microeconomics focuses on patterns of supply and demand and the determination of price and output in individual markets (e.g. coffee industry).

    Read more: http://www.investopedia.com/terms/m/microeconomics.asp#ixzz1phcz81a2

    Investopedia explains ‘Microeconomics’
    The field of economics is broken down into two distinct areas of study: microeconomics and macroeconomics. Microeconomics looks at the smaller picture and focuses more on basic theories of supply and demand and how individual businesses decide how much of something to produce and how much to charge for it. People who have any desire to start their own business or who want to learn the rationale behind the pricing of particular products and services would be more interested in this area.

    Macroeconomics, on the other hand, looks at the big picture (hence “macro”). It focuses on the national economy as a whole and provides a basic knowledge of how things work in the business world. For example, people who study this branch of economics would be able to interpret the latest Gross Domestic Product figures or explain why a 6% rate of unemployment is not necessarily a bad thing. Thus, for an overall perspective of how the entire economy works, you need to have an understanding of economics at both the micro and macro levels.

    Read more: http://www.investopedia.com/terms/m/microeconomics.asp#ixzz1phdquMcE

  • Bod

    The thing is that for the most part, when alternative investors short a stock, they’re not usually doing it because they’re gambling on its failure; or at least, not on its outright, smoking caldera of a failure.

    There have been, in the past, hedge funds who were forensic shorters – I’ve known a few quite close-up – but it’s never for the faint of heart, and the costs incurred in holding a short position will punish you, even if your assessment of the stock’s overall health is correct. They have to be able to predict not only that the event will occur, but they have to be pretty good at figuring out *when* the price is going to crash.

    No, three relatively ‘sane’ shorting strategies were/are “pairs trading”, merger arbitrage and convertible arb. Apologies to the cogniscenti if I’m teaching granny how to suck eggs, but here goes;

    Pairs trading allows an investor to capture the inherent increase in value of a well-run company in comparison to the economy as a whole. This was the original ‘hedge fund’ strategy employed by Alfred Jones in the early 50’s. The idea is that there are two primary trends in the valuation of a company. The first of these is due to the intrinsic value of the company itself, on the basis that a well-run, profitable company will experience a growing valuation. In addition to this, there’s the component due to the perceived valuation inherent to the activity of the economy in general. Hence, if you believe that Ford is basically a well-run business, and you believe that if you wanted to invest in US Auto-makers, that would be the best choice, you also *short* an average-performing (rather than a below-average) competitor (or even, nowadays, short an ETF or some other index-y vehicle that represents the sector as a whole). The short position is your insurance against price movements in the US auto industry as a whole, or as part of the entire US economy from a decline *or* advance. Hence in a perfect hedge, your return on the paired trades captures purely the valuation increase due to Ford being exceptional (and, axiomatically, reducing the volatility of the returns). It’s important to emphasize, that if you short the WORST auto maker in the industry, you’re not really pairs trading – you’re just making two back-to-back bets. In practice, keeping a perfect hedge on is hard work, and people who pairs trade end up with pairs that are imperfect for a bunch of different reasons, often because of transactional or executional complexities.

    The second strategy, Merger Arbitrage seeks to capture valuation changes inherent in M&A activity. When a merger or acquisition is announced, you’d go long the firm being acquired (on the presumption that the market, being rational, would have priced the stock correctly and seen the firm as a less competitive one) and short the acquirer, because its short-term price would be compromised by spending its capital on a new business which needed some care and attention. As a merger gets near to completion, you expect to see the share price of the target firm rise in comparison to the acquirer, with the roughly equal long/short positions cancelling out the background trends of the market, as with the ‘pairs trading’ strategy outlined above. There are lots of tweaks and enhancements that some managers exploit, such as opportunistic ‘pyramiding’ of positions when share price fluctuations occur, employment of matching puts and calls with varying prices (collars) etc. Unless a merger arb investor takes a position in a deal that falls apart (in which case the ‘connection’ between share prices breaks and he can get seriously mauled), it’s usually a somewhat gentlemanly progression from announcement thru’ the day the merger is finalized, where the share prices will have converged.

    Then there’s ‘Convertible Arb’, in which you’re buying preferred shares in a stock, and shorting the ordinary shares – you capture the dividend yield, and hedge out the equity performance. There’s not much activity in this area at the moment for a shedload of reasons, not least of which is the current corporate bond issuance environment. Pickings are thin, and will remain that way for some time.

    The important thing to note is that in their ‘vanilla’ form, the shorting component of all three of these strategies RELIES on the relatively predictable behavior of an underlying equity, and that its inclusion in the trade mix does not rely on the share price falling to zero (or even falling at all). In each case, a manager focussing on low volatility returns (which one presumes is likely to be one of the reasons he’s doing these kinds of things) will be utterly agnostic regarding whether he has to cover his shorts or not

  • I’ve heard explanations as to why things are done this way (usually because of government interference) but that doesn’t absolve the issue at hand.

    I’d tend to blame American tax laws, more than anything. A company pays corporation tax, then pays a dividend, and then the shareholder pays tax on that dividend again. This double taxation means that the overall tax rate on dividend income is quite high, and companies therefore prefer not to pay dividends. Compare this with the situation in Australia (in which dividends of profitable companies come with attached tax credits that shareholders can use to offset income taxes, the net effect being that the dividend income is taxed only once), and you find that Australian companies are much more inclined to pay dividends than US companies. Funny that.

    That’s an effective solution. Even better would be to simply abolish corporation taxes and allow dividend income to simply be taxed like any other income, but politically this just isn’t going to happen. We heard a loud criticism of Mitt Romney in this election campaign due to the supposed low tax rate on his investment income, which was just simply false, due to this precise issue. (Include corporate taxes paid by companies he owns shares in, and he pays taxes at quite a high rate). Any move to eliminate double taxation would be seen as a free ride either to rich people or to corporations, and would be a complete non-starter.

  • Jim

    It’s important to grasp the fundamental difference between SHORTING, and NAKED SHORTING.

    “Shorting” is done with a company’s own stocks; you borrow them from somebody, sell them, wait until the time you borrowed them for to run-out, then buy them again at the current price and give them back. If they went down, you win – if they didn’t, you lose. “Shorting is an unimaginably vital part of a successful stock market, because if investors don’t have a way to make money off a falling stock, they’ll stampede for the exit whenever a stock starts falling, selling everything and causing massive dislocation and instability in the market.

    “Naked shorting” amounts to selling stocks you do not possess. It’s open fraud, and since you don’t actually have any stocks, you can “sell” as many as you like. A company’s entire stock portfolio can be shorted in this way (why not? – think big!), driving its price through the floor and causing its bankruptcy – and all by a business rival who never owned any of it anyways and more-often-than-not, was motivated by nothing more than malice.

    – Which is why naked shorting is (or ought to be) illegal and very closely watched-for by the oversight bodies. Hope this helps… 😉

  • Paul Marks


    I despise the terms “macroeconomics” and “microeconmics”. Most of “macroeconomics” is just credit bubble theory and other nonsense.

    But is someone wants to use those terms…..

    Whether or not the government bans “short selling” is a matter of micro economics – i.e. how a market works.

    Short selling is (of course) a classic example of voluntarism.

    The coiners of the term (the Leeds Mercury people in the 19th century) would have understood this well.

    By the way I made a mistake – the name of the film was “Gabriel Over the Whitehouse”.

  • Jim: So the argument is that a naked shorts are bad because the total amount of shorting can be greater than the total outstanding amount of stock. Is that it?

    If you want, you can put the same downwards pressure on the stock price by constructing synthetic shorts on the derivatives markets (Take a long position on a put and a simultaneous short position on a call with the same strike price, or use CFDs, or….). Assuming the counterparties are out there, the total short position can once again be greater than the total outstanding number of shares. This will lead to the stock price going down the toilet in exactly the same way it would if the short positions were in actual stock. If the company is one that is unable to withstand a sudden collapse in its own stock price (probably due to itself being erected on large amounts of unsustainable leverage) it might get into trouble. If the company has cash reserves, assets etc (ie if it is actually solvent) then it will withstand this.

    If you want you can use this as an argument as to why derivatives markets are bad too, but I am hard pressed to see anything fraudulent in this. You just have contracts between investors being honoured.

    There really is nothing predatory investors can do with a naked short that they cannot also do with other instruments. If investors are ever asked to deliver the actual stock in accordance with market rules and find themselves unable to do so, that is problematic and might represent fraud, but as long as markets stay liquid, this is never going to happen. The alternative to delivering the stock is simply to close out your position, at which point delivery ceases to be your problem. (If this is the possibility that you are scared of, please tell me an example where it has happened. Any example at all will do)

    The possibility that delivery could conceivably be required does make a straightforward naked short messier at times and (as I said in another comment) this makes them maybe best avoided, but this really is a pretty trivial issue.

  • RRS

    M J –

    Agreed it is trivial -but it makes good “copy” for the SEC.

    Perhaps one thing to keep in mind is that derivatives (including options) trade in a different market from shares of stocks.

    That is not to say that the trading in the derivatives market has no effect on the shares markets; simply that the functions of the markets differ and serve different purposes or “ends.”

  • RRS

    M J –

    On further thought, some derivates do trade on the shares exchanges.

  • Dale Amon

    One commenter asked why someone would be stock from a party who does not have it (yet) and why they would let them capture the value.

    It’s the same as commodities futures in a way. The seller is betting the price will go down and he will be able to deliver the product for less than the agreed purchase price. The buyer is betting the prices will go up and the he will buy the product for less than the going price at time of delivery. The one who is correct makes a lot of dosh; the one who is wrong loses their shirt.

  • Jim

    M J:

    In my lexicon, Naked Shorting is bad because you are selling something that you do not possess (and that may not even exist). This is fraudulent – you are offering for sale to somebody, something that is not yours. I (shall continue to) fail to see how this can be described as anything but unlawful (despite arguments to the contrary). Sorry – that’s just me, regrettably.

  • Alisa

    Jim, IMHO it could be viewed as fraudulent if the potential buyer is ignorant of the fact that the seller does not in fact own whatever it is he is “selling”, and the “seller” is actively maintaining that ignorance. Otherwise, it is just another conditional ‘if – then’ agreement.

  • Also, I would add that by selling on an exchange, you are agreeing to comply with the rules of that exchange. Normally, they state that you must deliver the stock (whatever else is being sold) within a certain number of days if called upon to do so after the trade. In the event that this does happen, then yes, you must either obtain a share from somewhere and provide it, or transfer the obligation to provide the share to someone else, usually by closing out your position on the exchange. If there is any fraud, it only happens at the point when the short seller fails in that obligation.

    If I buy something on ebay, a seller will often claim that he has an item “in stock”, meaning he has it right now and will send it to me when I pay for it. A large online retailer such as Amazon will instead often say something like “Shipping within three days”. What this means is that they may not have it in there warehouse right now, but they expect to be able to obtain it within three days. As long as it is understood what the situation is, there really is no problem. Amazon are really good at inventory management, and so we trust them. (In the case of stock transactions, the equivalent of that inventory management is generally provided by the exchange, sort of).

  • Or maybe thinking about it a different way, an argument that has been stated here is approximately.

    (a) Naked short selling is fraud, due to the “naked” part.
    (b) Naked short selling is economically damaging.
    (c) (b) is because of (a).

    (a) may be true. Personally, I don’t think so, as long as it is understood that it is allowed and market participants all obey market rules.

    (b) may be true. Personally I don’t think so.

    (c) on the other hand, definitely does not follow from (a). One can trade in obviously non-fraudulent ways that do not involve the “naked” part that have exactly the same effect. It is trying to discredit the practice by arguing that there is something inherently dishonest about it that I have a problem with. Somehow excessive bullishness is a good thing and is the be applauded and cheered on, while excessive bearishness is a bad thing and is to be condemned. Why? The two things should co-exist, and hopefully cancel one another out.

    (Once upon a time, when I was working for a hedge fund, my boss rang me up and asked me to put on a short position on some foreign equities. Obviously I had to do this at once, so getting dressed was not my first priority. That or I thought the whole thing was funny…)