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Short selling is not evil, and it needs to stay in place if we want to have free markets. Short selling is a wonderful gift to liquidity and efficient price discovery. Markets thrive the more diverse the holders and traders of securities are. It’s what provides efficient pricing and liquidity for all investors.
Consider the plight of the mob of Tesla short sellers. In the seven months following the fateful brick through the cybertruck window, Tesla sold 650,000 cybertrucks that hadn’t even been made. The argument that short sellers can capitalize on high-profile bad news is invalid.
Elon Musk is sarcastic or self-serving. Short sellers might be the only thing distancing him from being worth more than Jeff Bezos (well, that and real economic value). At least a few of the 635,000 thousand people who liked his tweet, though, are probably thrilled that Citron discontinued short selling research this morning because, to them, short selling is evil and ought to be banned.
Without broad price discovery, the economy will suffer from less efficient capital formation. The value of short selling is going to be straightforwardly displayed in the next couple of weeks. GameStop (GME), which as of the posting of this article, surpassed United Airlines and 106 other companies on the S&P500 in market cap, is attracting retail investors who do not know what they are doing and want to get in on the fun.
GME is going to crash. With all the short sellers squeezed out of their positions, the stock price has become meaningless.
Many retail investors will not understand this and will buy GME at 336.19 (its price at 11:03 AM on January 29). When you bar short sellers (or discriminate against any class of market participant), retail investors are the victim. They are subject to a form of phony price inflation.
One could draw a parallel to silencing voices of political dissidence. If you ban the people who think your “price” is errant (too high), it looks like you (or your ideas) are worth more than they are. Get 1,000 people to go online and scream that the truth is a lie. It may work for a short time but ultimately the victim is the innocent participants who don’t have the time or the expertise to adjudicate the truth on their own. Making markets free helps innocent participants. Allow all ideas and opinions to have their say, and the truest ones will rise to the top. Price discovery and public debate have similar dynamics. Both discern the collective truth.
If your problem with short selling is that you think it's an evil way for “fat cats” on Wall Street to get richer by betting against the little guy, think again.
Short selling does bear one major similarity to evil; it rarely pays off in the long-term. “The stock market always goes up,” is a commonly repeated and dangerous phrase, but it's actually accurate. Since 1980, the S&P500 has been up in 76% of six-month windows. So by definition, most short trades are losers. The truest depiction of short selling is not Ryan Gosling getting a $47 million check for his risky bet against the American housing market in The Big Short. It’s a long-short equity manager who is exposed to more retail risk than he’d like and short sells Cheesecake Factory (CAKE) for three months. Then CAKE rallies 14% for no discernable reason, and he’s forced out of the trade.
This is a funhouse image of the landscape of market participants, which, like most things in our society, is very complex. Before you go celebrating Melvin’s big loss on GME, here’s an interesting fact: U.S. pension funds, who manage the retirement funds of our nation’s teachers, firefighters, etc., allocate over $900 billion to more than 2,500 long-short equity investment managers, like Melvin, as of March 2019. The hundreds of millions of dollars Melvin lost this week did not come out of Steve Cohen’s bank account. The big scary institutional investor is often an amalgamation of little guys, not so different than the Reddit GME mob.
Retired hobbyist investing, momentum investing, value investing, short-term mean reversion like statistical arbitrage, growth investors, day traders, short sellers, even Reddit mob investors: They’re all part of a market mechanism that ultimately leads to better long-term price discovery and adds depth and liquidity to the market place. Whether Tesla is worth $1,500, $800 or $50 a share, this mechanism flushes out the true long-term economic value of a security.
Ban short sellers or any other market participants at your peril.
Neil Ramsey is the founder, chief executive officer, and chief investment officer of Ramsey Quantitative Systems, Inc. (RQSI). Since the firm’s founding in 1986, Neil has been involved in the development and execution of the quantitative and systematic trading models that constitute RQSI’s investment strategies.
John Ramsey is the portfolio manager of Ramsey Quantitative Systems, Inc. (RQSI). John researches and develops mathematical models for use in systematic trading and is responsible for the development of bespoke systematic global macro products within the firm's suite of investor tools.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.