The U.S. House Financial Servies Committee held hearings last Thursday on the GameStop saga. Lawmakers from both sides of the aisle broached the prospect of additional regulation of short selling. Should Congress follow through with such action following two more scheduled hearings, that may do more harm than good, because it could make our capital markets less efficient — especially if based on a poor understanding of the role of short-sellers.
It was suggested short-selling hurts “ordinary investors and families.” Such a characterization of short selling is misguided. Short-selling practitioners make easy scapegoats since they profit when the share prices of targeted companies go down. But this oversimplification obscures the important and positive role short sellers play in our capital markets. If anything, their actions are an important mechanism by which stocks are prevented from deviating significantly from their fundamentals.
The events in January surrounding the dramatic rise and subsequent fall in the price of GameStop gave critics an opportunity to push their anti-short selling narrative further off course. It is lost on these critics that short sellers play an important role in our society by facilitating efficient resource allocation, uncovering corporate malfeasance, and — contrary to conventional wisdom — placing a floor in stock prices when they are in free fall. They do so by identifying over-valued securities and betting (take a short position) that the price of the securities will fall. Though it may seem counterintuitive, short sellers play an important function in a capital market-based economy because the price is an important indicator of a firm’s value and its prospects. Thus, the price of a firm informs the investment and resource allocation decisions of investors and corporate managers.
A fair and efficient price, which incorporates both good and bad news, is essential to facilitating efficient resource allocation in our economy. On the other hand, when prices deviate significantly from fundamentals, it sends the wrong signal to investors and management, who may act on that signal and make ill-advised investments resulting in poor resource allocation — and that causes value destruction in our economy.
The 1990s tech bubble and the housing crisis are prime examples of how overvalued stocks can prompt bad investment decisions and produce negative consequences, not just for investors in the stock market but also for the economy and society. Markets need a mechanism to correct severe overvaluations in stocks, and this is where short-sellers come in. Short selling is risky, as the downside is theoretically unlimited, which is why short-sellers engage in extensive research before taking a short position. Consistent with this view, a large body of academic research has shown that short sellers are informed investors, and hence on average, their bets are correct — that is, heavily shorted stocks underperform, on average.
In addition to correcting overvaluation, short-sellers act as market detectives who risk both capital and reputation to call out aggressive accounting and fraud. And while prominent short sellers, such as Jim Chanos, grab headlines for uncovering the likes of Enron and Valeant Pharmaceuticals, every year a small number of vocal short-sellers help sniff out the type of brazen stock promotions to which retail investors are most likely to fall prey.
Though some critics say short-sellers drive prices down, in reality, they set the floor when stock prices are in free fall. Short sellers build positions as stock prices move up, so at best they are a countervailing headwind to rising prices. Prices only begin to fall when long investors sell as they begin to price in the “truth” that the short sellers sniffed out. Short sellers then help find a floor in pricing when they cover their positions, which requires them to buy the stocks.
We believe it would be a major policy error for regulators to clamp down on short-selling as it would make prices less informative and markets less efficient. It is not clear to us that “ordinary” investors have the resources necessary to meaningfully research a short target. This activity is best left to the professionals. However, given the growing trading volumes of individual investors, societal resources could be better spent on educating investors about the functioning of the financial markets, the risks involved, and understanding the role of all participants in the market.