Wednesday, 1 October 2008

Short thoughts

I thought I'd splurge some general thoughts about short-selling because I'm not sure that (so far) I agree with any commonly articulated viewpoint. These aren't very technical arguments, so I'm very open to comments/corrections from more expert views on what really happens. Anyway here goes.

1. I've always thought, and recent events reinforce my view, that stock-lending to facilitate shorting is an odd thing for long-term investors like pension funds to engage in. Put simply, you are renting your asset to someone who is going to tell the market that it's overvalued. By definition they expect the value of your asset to drop, and hope it does. And they aren't going to be shorting a company if they only think it's a bit over-priced. So unless you are making a bundle out of stock-lending to offset the potential drop in value this seems a bit counter-productive.

2. I don't think I buy the argument that shorting brings prices back to realistic levels. As I posted previously, academic evidence appears mixed. And real-world experience seems to point in the other direction - see the TMT bubble for details. Also this argument implies that those shorting are more rational, or have a better idea of the 'true' value of the stock, but why should that be that case? And even to entertain the idea that it were true perhaps - again thinking of the TMT bubble - the sceptics will never be strong enough to overwhelm the rampers. So perhaps all shorting does is accelerate and accentuate the drop when it comes.

3. Is shorting, as is sometimes implied, really just the mirror of going long? If so where do selling, and not buying fit in the spectrum? Isn't selling the opposite of going long and as such shorting almost a sort of leveraged position?

4. Pointing in the other direction, let's not fall into the trap of thinking that shorting is inherently more speculative than buying stock. Yes, those shorting typically only borrow stock for a limited amoung of time, but is this any different from those trying to profit from a post-IPO surge, buying shares in companies about to enter key indexes (and hence whose shares will be boosted when index-trackers have to buy), or engaging in momentum trading?

5. Equally let's be careful about the way we describe shorting. It's not really selling something you don't own, which makes it sound to the average punter to be almost fraudulent. It's renting something, selling it, buying it back, and returning it. Put like that it makes it much clearer that the person shorting is undertaking a risky activity but the ownership issues are clearer.

6. Time to hold our hands up - the corporate governance & responsible investment world I inhabit has appeared irrelevant by not making more of an issue out of this. We (me personally) have tended to focus on the obvious ownership policy issues - like what happens to voting rights when stock is lent - rather than focusing on the big stuff. The ability to vote on the report and accounts doesn't matter much if the company ends up being taken over/nationalised/etc.

So - where am I right and where am I wrong?


Nick Drew said...

well you know my headline views. #4 is right - going short is in most ways symmetrical with going long, it's just that many people don't know how to go short.

let's first of all agree that people seeking to manipulate markets - using shorting or any other means - belong in an unpleasant jail


I think what underlies many folk's hostility to shorting, where they wouldn't be hostile to speculating on the long side (though they'd probably much prefer to call it 'investing'), is that investing can give the warm glow of 'helping a worthy business make its way in the world' (spurious, of course, unless it's a new start-up)

whereas shorting is 'betting it will fail', an altogether nastier sentiment

ignoring the fact that betting one company will prosper / helping it to do so, is often tacitly to bet (/ help ensure) that another will fail anyway

but so many of the technicalities of finance (even the trivial ones) are a little abstract, and seemingly counter-intuitive to many

Andreas Paterson said...

I think that on point 1. most lenders view themselves as in it for the long haul and consider that if the shares are going to lose value anyway then it's worth making a bit of money from it.

Dividend yields are not all that related to share prices and if the business is fundamentally sound then there's a good chance the price will recover in the long term.

That's what I reckon anyway.

Tom P said...

cheers for comments, dunno if I have much to add. still not sure I buy the argumemt that shorting is the mirror of going long though, Nick. but I can't quite put my finger on what it is that bothers me about the argument. it's not the fact that you are betting against the company.

Some people have made the argument that allowing shorting of housing (would obviously need the creation of a new market) could have kept prices in check. Does that make any sense? And if it does why don't we have shorting of other types of assets/goods etc?

Anyway, I'll try and straighten my thinking out about this and have another go in a couple of weeks.

Steven_L said...

Tom, a house is not a liquid asset is it? Not only that, they are all unique (unlike say the ordinary shares of HBOS, which are all exactly the same).

I can't see any way in which you could create a virtual market for houses that would allow people to go short.

There's all sorts of stupid comments circulating the internet at the moment. I'm afraid creating a virtual market in which to 'trade' each other houses is on a par with the Jewish banker consiracy theories.

Nick Drew said...

yes, absolutely, you could short housing, nothing could be simpler - with a new market, as you say. It would be settled against a reliable index of house prices, ideally with regional basis-points and an associated forwards market

the benefits of such a market would be great

(a) as you hint, it would have been very valuable against the Brown Boom, and would have undoubtedly blunted it (because loads of people knew it was a bubble), to all our benefits. (In the absence of such a market, how many people could seriously contemplate selling+renting in order to go physically short, in response to bubble-pricing ? Some people did, of course, but there are major inhibitions, not least the grotesque transaction costs and the scale of the short position you need to take on - how many punters can afford a £ X00,000 short ?)

(b) for example, if you knew you were going to move to a new job + new house in a different region 6 months hence, and wanted some certainty on price-differentials, you could lock in today's differential in such a market

(c) if you were going to retire in, say, a year's time when you would sell up and downsize, and you feared there might be a downturn in the market in that period, you could lock in today's price in such a market, or cap your loss

etc etc

bring it on ! (incidentally - *little-known fact* - at the time of their demise Enron were planning to set up just such a market for the commercial property market (where pricing is more transparent, being denominated in £/sq ft): they were going to buy Canary Wharf to get the show on the road !)

(I could describe the preconditions for such markets to work but equally I could bore you rigid)

Steven_L said...

Nick, you amaze me, I just can't get my head around how it would work.

Nick Drew said...

think spread-betting

(err ... are we allowed to mention betting these days ?)

Nick Drew said...
This comment has been removed by the author.
Steven_L said...

I am thinking spread-betting, but don't market makers hedge their exposure by buying or shorting actual shares? Like a small bookie laying off his bets with a bigger one?

How can an exposed market-maker lay off short exposure to the housing market?

I just can't see how this would work.

Nick Drew said...

check the *little-known fact* I gave above - Enron were going to get the ball rolling with a large physical position

loads of organisations hold big (physical) portfolios of houses

(as it happens this isn't strictly necessary, the key factor is a reliable index and some different viewpoints on the direction of the market - plus some liquidity !!)

when the interest-rate swaps market first got going (early 80's), sometimes weeks would go by without a trade: the first market-makers were in 'broker' mode, painstakingly beating the bushes for natural counterparties