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Why armchair investor movement is wrong about short-sellers

Written by on 01/02/2021

Sticking it to the man is something beloved of rebels down the years.

A quick stroll through the WallStreetBets (WSB) forum on the social media platform Reddit suggests this is a major motivation for a lot of the amateur investors punting stocks such as GameStop.

They have revelled in the carnage inflicted on hedge funds, such as Melvin Capital and Maplelane Capital, who had been ‘shorting’ the video games retailer – in other words betting on a fall in its stock price – and got caught out when the WSB investors piled in using traded options.

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Real Wolf of Wall Street on GameStop stock chaos

Here are just a few of the comments:

“We all know we’re buying and holding GME [the stock market ticker for GameStop] no matter what f***ing happens so we can stick it to the hedge funds.”

“We’re not the bad guys. The bad guys are the ones that would crash the market.”

“We’re not causing the next crash, we just prevented billionaire-gang mega-short hedge funds from causing the next one on purpose.”

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This is in keeping with the philosophy that has underpinned investment bulletin boards which have flourished on both sides of the Atlantic for more than 20 years now. Short-sellers are evil, the argument goes, because they are deliberately betting against honest businesses and, in some cases, actively trying to bring them down.

It is not a sentiment confined to amateur investors on WSB.

The US House Financial Services and Senate Banking committees are to hold hearings on recent events in the stock market that will include looking into the role played by hedge funds that were short-selling GameStop.

Alexandria Ocasio-Cortez, the left-wing Congresswoman from New York, who sits on the House Financial Services Committee, tweeted last week: “Gotta admit it’s really something to see Wall Streeters with a long history of treating our economy as a casino complain about a message board of posters also treating the market as a casino.”

All of this, unfortunately, misses the point.

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GameStop investor: ‘It’s about sticking it to the man’

The idea of short-selling may appear, on the face of it, to be immoral. The idea that an investor is seeking to profit from a fall in the share price of a company, a share price fall that may even hasten the demise of that company, will not sit easily with most people.

Yet short-sellers play a vital role in the efficient functioning of stock markets.

A market, after all, is where buyers and sellers come together and the price of any security traded on that market is determined by the readiness of market participants to buy or sell. If there are no sellers in a market, but only buyers, share prices would only ever go up. So short-sellers help play a vital role in what is known as ‘price discovery’ – the process whereby the price of a security is determined by the coming together of buyers and sellers.

They also contribute to liquidity – the ease with which a security can be bought and sold. A market where there are few or no sellers, only buyers, will be illiquid and price movements more volatile.

David Schwimmer, chief executive of the London Stock Exchange Group, said on Monday there was an element of misunderstanding of the way short-sellers operate.

Speaking to Sky News days after LSEG completed its blockbuster $27bn takeover of the data giant Refinitiv, Mr Schwimmer – who has spent more than 20 years working in markets – said: “Short sellers are part of the market in terms of expressing a view.

“They may express a view that some people don’t like, when they express a negative view, but that is what makes a market in terms of having positive views and negative views.

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London Stock Exchange boss warns of ‘damaging’ distortion

“The market is the best tool we have for incorporating all of those different views and coming up with an aggregate view of the market perception of appropriate pricing. When you have intentional distortion of those market signals, that really is damaging from a market perspective.”

Short-sellers, in exposing the shortcomings of failing businesses and helping hasten their demise, arguably do a wider good for society – enabling capital tied up in those businesses to be more effectively deployed elsewhere.

They have also often highlighted skulduggery, such as in the case of Wirecard, the German payments company. Short-sellers had argued for years that the business had been trading fraudulently. Wirecard used every lawyer at its disposal to try and silence its critics but, eventually, collapsed after conceding its accounts were fictitious. The scandal would never have come to light were it not for the short-sellers and the Financial Times reporters who gave them a voice.

Wirecard was once valued at as much as $28bn (£22bn)
Image: Wirecard was once valued at as much as $28bn (£22bn)

Further back, investor Simon Cawkwell – the London-based short-seller famous for using the non-de-plume Evil Knievil – was the first to expose dubious accounting practices at businesses owned by Robert Maxwell, the crooked former owner of the Daily Mirror.

Mr Cawkwell is a classic short-seller in that his research is meticulous. If you buy a security and its price falls to zero your downside is limited, whereas if you go short of a security and its price rockets, your downside is in theory infinite. So short-sellers tend to do more research because they take much more risk.

It is also possible to argue that some markets need more, not fewer, short sellers.

One arguing this is Robert Shiller, the Nobel Prize-winning professor of economics at Yale University, who was one of the first to flag concerns about the creation of a US housing bubble in the mid-2000s – the bursting of which subsequently led to the global financial crisis.

Professor Shiller has suggested that, had there been more ways to speculate on a fall in the US housing market, the ‘price discovery’ process would have been more efficient and house prices would not have become over-inflated.

It is also worth noting that, where regulators have sought to ban or restrict short-selling, it has not resulted in smaller falls than markets where short selling faced no such restrictions.

The investors on Reddit can complain all they like. Short-selling is a vital part of how markets should function. No-one seriously interested in markets operating efficiently will want to abolish the practice.

 Sky News

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