After several months of steady economic recovery and market ascent, we suddenly find ourselves in yet another alarming moment of economic uncertainty and potential peril. Thanks to a historic rise in inflation, the Federal Reserve just moved up its timeline for rate hikes. Stock prices quickly took a downward turn, signaling the possibility of a new era of market volatility. At the same time, some in Washington seek to reimpose on the United States the industrialized world’s highest corporate taxes and even begin taxing all financial transactions.
Amid all of this, the ability to anticipate market developments and pivot quickly becomes even more important, particularly for institutional investors like pensions which require reliable returns for their members.
Unfortunately, too many activists and political leaders, fueled by the GameStop and other so-called meme stock volatility episodes, remain stubbornly obsessed with demonizing and restricting one of the most important tools for navigating a volatile market: short sales.
A corrective to the anti-short sales campaign is therefore needed.
“Short sales” simply refer to financial transactions executed when traders consider certain stocks overvalued. In such cases, traders borrow the stocks in question at current market value and then sell them to willing purchasers at that same price. The short sellers then wait for the stocks’ value to decline, at which point they buy the same stock at a lower price than the price at which they borrowed and sold the stock. Finally, they return that stock to the original lender from whom they initially borrowed, thus profiting on the difference.
To illustrate, imagine an investor who believes that hypothetical Stock A’s current market price is overvalued at $100 per share. Accordingly, that investor borrows Stock A at $100 per share and sells it to another buyer at that same price. Later, imagine Stock A falls to $50 per share, at which point the investor snatches up shares to return to the original lender. Since the stock that is being returned to the original lender was bought for $50, the investor pockets a $50 per share profit, which was the difference between the $100 per share sale of the borrowed stock and the $50 purchase of the replacement shares.
It’s important to remember, however, that there’s no guarantee that the short seller’s expectation of a stock’s market price decline will actually occur. If Stock A’s market price instead increases to $150 per share when the borrowed shares must be returned, then that investor loses $50 per share from having to purchase shares at a higher price to return to the original share lender, thus paying the price for an incorrect expectation of share decline.
That’s how markets work and should work.
Accordingly, short sales are perfectly logical and legitimate transactions for traders who believe that a company’s stock is overvalued. Indeed, the Securities and Exchange Commission (SEC) determined short sales account for fully 49 percent of all listed equity share volume, and The Wall Street Journal’s “Business World” guru Holman Jenkins highlights how there’s nothing salacious or even extraordinary about them.
Moreover, short sales serve a critical signaling role in markets and our economy, which is why efforts to restrict or even prohibit them are so dangerous. Contrarian short-sellers challenge conventional market wisdom, and thereby help identify potential bubbles, overpriced stocks, and wise investment opportunities. The stocks in question might be overpriced due to underlying improper internal business practices, as was the case with Enron, Tyco, and Worldcom. In other instances, the subject stocks might be overpriced due to looming technological innovations or market changes, and short selling signals approaching downturns like the 2008 housing market collapse to the rest of the world.
Nor is this a particularly American dynamic, as Britain’s Financial News recently reported, “Short-selling investors, including hedge funds, helped public pension funds and European regulators by exposing the massive accounting hole at high-flying fintech company Wirecard. Nearly $2 billion in cash is missing and no one knows where it is or if it ever actually existed. The firm’s former CEO has been arrested and the full extent of the cover-up is to be determined. But for the important work of short-sellers, investors across Europe would have kept pouring cash into the firm.”
Accordingly, short sales provide an invaluable market service by sending important signals to investors and consumers, thereby protecting investments and people’s savings.
The effort to restrict or even prohibit short sales would inhibit American markets and investments at the worst possible time. What the American economy needs at this moment of sudden peril is more certainty and flexibility, not less.