Thursday 18 September 2008

Caught Short

Apologies for another long blog on financial markets.

Its become fashionable to blame "short sellers" for share price falls. They have become a new evil.

I'm not sure why: if I want to buy a share I need someone to sell it. Short sellers are therefore very useful in making markets work. If there are as many buyers as sellers, then they can't force prices down.

It's as sensible to blame the rest of us for not buying shares as it is to blame those who sell.

(This is a bit simplistic: a short seller makes money from selling shares he doesn't have and buying them back later when the price is lower. Three things are needed for this tactic to make money:
- as above, there aren't enough buyers
- people who already own the shares (in most cases the people who manage our pensions) lend them to the short sellers so they can deliver them to get paid. Yes, the people who own shares facilitate people wanting prices to go down)
- in the long term, the company has to be overvalued: in fact, both the short seller and the people who didn't buy have made the right decision. And surely should not be criticised. There is one exception: when false rumours are spread. I am sure this happens occasionally. I'm also sure the impact is exaggerated because most people know when something is false, and the amounts of short sales just aren't enough to make a big difference. But when it does happen its illegal although almost impossible to prove.

So the conclusion above mostly remains: sharp price falls are the result of people not buying, not short sellers. And most analytical work has shown that if short selling is prevented it makes share prices more not less volatile.)

Post script: Since writing the above, the regulator (the FSA) has just announced a ban on new short selling; I haven't seen the detail but this has me more worried about markets than anything I've seen so far. It suggests an attempt at market manipulation, probably politically driven, which will make the eventual resolution of problems worse and longer than it need have been.

On a related subject, Antoine Kaletsky in the Times today suggests that the current action by the regulators may not be enough and that banks may have to be nationalised. This did of course happen in the Scandanavian countries in the 1990s. It mostly worked well: shareholders and managers lost out, depositiors, borrowers and tax payers didn't, and it allowed the banks to be restructured, the bad stuff to be gradually worked out and the normal business to be sold back into the private sector. If this happens, don't panic. It would be part of the solution.


Troy said...

Now it at least feels like a level playing field for the private investor - I say perhaps naively.

John Woodman said...

?? I don't understand. The private investor has been able to short sell for ages - and frequently does.

I think private investors who try to trade intra day will always be at a disadvantage unless they talk to others and pay for up to date information. But most don't.

My next (and I promise my last for a bit) post on financial matters will comment on investment styles.