Re: 3/1/05 - My Reply to Bob O'Brien on Mark Cuban's Blog
Unlike basketball (to which someone here lamely tried to analogize), the stock market is not a contest. It is a marketplace. The predominant goal is to make money betting on whether a security will go up or down. However, like a contest, the "loser" often would rather blame his failure on someone or something other than himself.
Studies have shown that shortsellers have been blamed for market declines since the inception of the stock market. New theories of how to "cure" this alleged problem surface every few years. Five years ago the cry was to call in your certificates. A couple of years ago it was to abolish the DTC and return to paper certificates. Now, thanks to people like Bob O'Brien, abolishing naked short selling is the medicine of choice.
Simple, logical analysis shows how misguided the anti naked shorting crowd is. For example, here are a few *myths* exposed:
1. We Need to Eliminate Naked Short Selling to Level the Playing Field
The risk of going long is finite in that a stock will only fall to a value of 0, thus limiting your liability to the amount invested. As a stock may rise indefinitely, the money necessary to cover a short is theoretically unlimited. Obviously, the playing field is not just un-level, it is tilted to create a slippery slope for short sellers.
Furthermore, one can buy a stock whether the price is going up or down. The "Uptick Rule" prevents shorting a stock whose price is on the decline.
Next time someone tries to soft peddle their opposition to naked short selling as "I just want to make sure both sides play by the same rules," ask them if they are in favor of capping risk on short selling and abolishing the Uptick Rule.
2. Naked Short Selling Destroys Innocent Thinly Traded Companies
According to a study of market manipulation cases brought by the SEC between January 1990 to October 2001, entitled "Stock Market Manipulation - Theory and Evidence", "84.51% of manipulation cases involve the inflation of stock prices while less than 1% of cases involve the deflation of stock prices. Stabilization accounts for 2%. For about 13% of cases we do not have enough information to classify the type of manipulation." [1]
Another study, entitled “The Long and Short of Hedge Funds: Effects of Strategies for Managing Market Risk”, analyzed the performance of companies that complained about excessive shorting of their stock: "Firms don’t like it when someone shorts their stock, and some firms try to impede short selling using legal threats, investigations, lawsuits, and various technical actions. Consistent with the hypothesis that short sale constraints allow stocks to be overpriced, firms taking these anti-shorting actions have in the subsequent year very low abnormal returns of about -24 percent per year. The negative returns continue for up to three years. What appears to be happening is that these companies are overpriced, either because of excessively optimistic investor expectations, faulty products or business plans, or just plain fraud on the part of management." [2]
Conclusion
Given the inherent risk in going short a stock vs. going long, any argument in favor of further constraining short sellers in order to level the playing field is fallacious. It's precisely this added risk that makes it much more likely a heavily shorted stock indicates a less desirable investment in general. With frauds of massive proportion like Enron, Worldcom, and Tyco -- not to mention absurd abuses by mutual funds, investment houses, and even media talking heads -- the SEC, and presumably Mark Cuban, should have a much higher agenda than wasting time battling the latest fad excuse for why someone like Bob O'Brien's pet stock is not making him rich.
Sources (highly recommended for further reading):
[1] sec.gov
[2] financialservices.house.gov
For a chronicle of investment chatboard related lawsuits, maintained by the author, see:
Subject 28509
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