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Short on logic

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How much is something worth? Whatever someone will pay for it. This has been the fundamental faith of the believers in the free market ever since the labour theory (that the value of a good depended on the amount of work that had been put into it) was soundly repudiated by economists

Yet short sellers, the financial market “bears” who have apparently caused so much devastation to banking in the US and Britain in the last few months, have a different, and somewhat unorthodox answer to the question. Something is worth what we say it is.

They aren’t being arrogant. They are simply saying that they know the true price of a share, the real objectively arrived at value of it, and that the market is wrong. And they are happy to share this knowledge with the world — once they have made pots of money by selling companies short.

What they do, put simply, is to spot mispricings of shares — the market gives them a higher value than they should have because the market has failed to take account of some factor that should push the price down. The bears step in: they borrow, let us say, a million shares from someone who is holding them long term (and pay a fee to do this) then sell them. When the shares fall (because the market has suddenly realised it has been mispricing them), the short seller buys them back at the lower price, hands them over to the owner and pockets the difference between the higher price at which he sold them and the lower price at which he bought them back.

Underperformance

Of course it would be unwise to short a thoroughly healthy company. You might find the market saying, we’ll take your borrowed shares and any more you have please. When you come to close your positions (ie buy back the shares to return to their owner) you may find little difference between the price you sold at and the price you are forced to buy back at — hence no profit to be made (there may even be an embarrassing loss).

The defence made of short sellers is either that: a) they are bravely exposing the real value of shares in companies whose underperformance has gone unnoticed or has been deviously kept hidden, thereby providing the valuable policing service of “price discovery”, bringing to light the true value of shares for the benefit of efficient markets; or b) they are a brutally oppressed minority heroically refusing to go with the herd and instead bravely taking a real risk for the sake of the higher good — up there with Galileo, Gandhi and Martin Luther King (the argument being that the long term tendency of shares is to rise so short sellers are doing something rather special and risky in taking a bearish view — and backing their view with other people’s money).

The last argument is simply a way of trying to counter the view that short sellers are making easy money with what amounts to a trick. In fact what we are doing is really, really hard, they say, and it takes real guts and everyone’s against us and why don’t you all leave us alone?

The first argument, though, is the one that needs to be taken seriously, not least because it is accepted orthodoxy in the world of finance and economics yet is based on a contradiction: the mysterious confidence in there being an objectively right price for goods at the same time that the only right price is the price people will pay for them — a market price based on the aggregate subjective views of the people buying and selling the shares.

Dominant

The problem is that the short sellers are making use of the borrowed shares to do two exactly opposite things in the market. The shares remain, to all intents and purposes, in the hands of the original owner, say an institution wanting to hold them long-term. The fact that they are holding them tends to buoy up their value in the market — the more that are held rather than sold means there are fewer to buy; short supply tends to raise price.

At the same time the very same shares are being sold in the very same market — tending to drive the value down, since that is what happens when supply in the market rises.

The two effects, of course, don’t cancel out. The sale of the shares becomes the dominant tendency since it is no different from the long term holders actually selling the shares. As far as traders are concerned a million shares have suddenly been dumped on the market. Greater supply without greater demand means the price must fall; add to that the confidence factor — if these shares are suddenly on the market, there must be something wrong with the company so the traders mark them down even further; and add to that the blackguarding of the company, publicly and/or secretly, by the hedge fund employing the short sellers and you add another twist to the downward spiral of the share price.

Yet, the original holders of the shares have no intention and had no intention of actually selling the them. The original price was right, as far as they were concerned — a hold, in the jargon, with some expectation of long term growth. So exactly what price has been “discovered” by the actions of the short sellers? A wholly false price, one based on layers of fiction and market misinformation. What they are doing, far from “discovery” of a true price, is injecting false information into the market — the information that there are a million shares available to buy when in fact there aren’t.

There is nothing wrong with making money from other people’s misery — it is and always has been fundamental to the capitalist system. But you can’t have it all in this world. You can have the penthouse, you can have the cadillac, you can have the yacht —but can’t also expect to have the moral high ground.

For an alternative view:

http://www.guardian.co.uk/commentisfree/2008/sep/19/marketturmoil.lehmanbrothers

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About alrich

Journalist and blogger on legal and financial/economics issues

One response »

  1. It is very rich of the filthy rich to claim any moral high ground but, to me, the “blackguarding” of the target of short-selling is not just “another twist” to the practice but absolutely central to it and underlines how easy it is to manipulate the markets.
    You don’t have to declare your stake (except now in a few dozen financial stocks – and even that is temporary) and can start a rumour that will go through the market like wildfire because what else is a stock market but a place where those privileged enough to be privy to sensitive information can make money by acting before the rest of us?

    Reply

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