Saturday, 24 January 2009

Shorting again

There's a nice bit from Robert Peston about the end of the shorting ban here. It's a good defence of the practice, and he's come out clearly against the idea that the end of the shorting ban explains the slide in bank shares over the past week:

Most of the share price movements in the big banks have been caused by conventional selling of shares by the normal gamut of investment institutions.
Some of these investors may have sold because of their conviction that the shorts were selling the stock down to zero. In fact a number have told me precisely that.

The second sentence is the one that interests me. If, like me, you think stock markets are a lot more about psychology than efficient factoring of information into prices, then this makes a lot of sense. Short-selling may indeed have a minimal influence directly on share prices, but it can have a seconday impact because of the influence it has on other investors' views. I don't know if anyone has done any research on this subject, but I suspect if we want to get anywhere in a proper discussion of the rights and wrongs of the practice it's something that will need to be considered.

There's another bit earlier in Pesto's piece that grated with me though because it seems a bit inconsistent:
As we surely must now appreciate, as we live with the bitter consequences of the popping of the debt bubble, the euphoric buying of assets by manic investors is highly dangerous - so it can be very helpful that the market contains short-sellers expressing a contrary, negative view.

This is a very common argument, but is it actually proven? It doesn't make a lot of sense to me. I mean we've had shorting in the bank stocks for all but a very brief period, but they still became over-valued and had to crash back down. Ditto during the TMT bubble. So I don't think shorting really brings anything extra in terms of market effciency or rationality, it's just more trading so more costs.

I think the problem (for both its critics and defenders) is the implicit idea that shorting is some kind of inherently different technique, when surely in reality adopting and then unwinding a short position is ultimately just another couple of trades. Viewed in this way shorting doesn't look so evil, but neither does look like it brings anything different to the market. And in any case, people who think certain shares are over-priced sell them every day, so negative sentiment is already expressed. Why else would bank shares fall (as Pesto says) even when there isn't much shorting going on.

It seems a bit inconsistent to me to argue both that markets are capable of major 'corrections' in prices without the presence of shorting, and that shorting is valuable because it prevents stocks becoming over-valued.

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