Monday, March 2, 2009

Government should ban short selling

The US Economy and the stock markets look scary these days. There is a panic among investors. Stock prices have come to a level un-imaginable by most.
On one hand Government is doing all it can. Billions of dollars are being loaned, invested in troubled companies, bad loans, bad securities. New legislation is being passed to jump start the economy. There are tax rebates and relief checks are being given to millions of taxpayers. However nothing seems to work. (I know ultimately it will work; it is just a matter of time). The prices are still continuing to go down. Nobody seems to have a handle on current situation. I don't pretend to know the root cause of the issue. However here are certain things I believe should be done asap.

1. Ban Short Selling: Does the economy drive the stock market or is it the stock market that drives the economy? So far I believed that it is the economy that drives the stock market but now I tend to believe that there are **times** when the stock market actually drives the economy. When a market (stock, real estate, bonds or any market as such) goes up, it pushes the economy artificially higher and the same things happens when these markets go down, they cause economy to suffer too. Any excess move by prices in any one direction can cause economy to move out of its sustainable long-term range. It is not true to say it is only the economy that causes the stock prices to go up or down; I believe stock prices can also cause the economy to expand or contract. In current scenario of panic in the market, let us say a stock is falling. That scares not only its investors but also its lenders. If the stock falls below the comfort level of some lenders, they become vigil. Then, some smart lenders to try to be ahead of the race and if they can, they withdraw their credit from the company. What was a fear so far starts turning into a reality. This creates another scare among market participants. That causes remaining lenders to panic. Nobody is willing to lend more money to the troubled company so bankruptcy becomes in-evitable. Company lays-off workers and cuts down on its spending (current or capital) which in turn affects the economy.
My point is: if the price of a company's stock falls below some level, it can really push the company into a bankruptcy. I am not trying to tell you that nobody should sell a stock. Every investor has right to sell his holdings if they lose confidence in the company they are invested in. I do not mind short sellers to go short the stock too but I like to see short selling of a stock allowed only in normal economic conditions. When markets are in panic, any small trigger, can become a snow-ball of problems. In such fluid market conditions, in my opinion, short selling should not be allowed.
When the Government is pouring billions of taxpayer dollars in stabilizing the economy and prices in the markets, short-selling defeats the purpose. I am surprised to see that short-sellers are still able to push companies into bankruptcies in such a bad economic environment. I was reading somewhere (I think it was LA Times) that for the last few months, the return on S&P was -12% or so but average return on hedge funds that primarily engage in short-selling was positive! This just proves that they are still people and institutions trying to profit by acting contrary to what Government is trying to accomplish with our billions of dollars.
Remember that the fundamental basis for an efficient market is dynamics of demand and supply. In my opinion, short selling is an artificial addition to the supply. If you have something, you can sell it but if you do not have it, how can you sell it? I want to short-sell (not in the real-estate short-sell terms but in the stock market short-sell meaning) my neighbour's house but I can not do it because it is not mine. I can not short sell air-line tickets, vacation packages, NBA game tickets, computers, monitors, memory modules, gold etc. I know you will come back and tell me that I can short sell Gold Futures. I am not talking about Gold Futures; I am talking about Gold as a commodity. If we have Futures on individual stocks, that is fine for one to sell the Futures. Remember that Future contracts are created at will by an agreement between a buyer and a seller. However short-selling a stock is a weird concept because stocks are usually created by the issuing company- you or I are not allowed to create them at our will. Here a short seller just creates some supply of the stock out of the thin air and pushes the price of the stock down.

How Short Selling works in reality? In my previous statement, I said that short sellers create new supply of stocks; I am not saying that they create new stocks. A short seller actually borrows stock from some current holder and uses it to sell. Over the years, the stock lending systems have become so perfect that most of us have lost control over it. They are transparent to us. Probably the Apple stock you are holding in your account may be used by some short seller to actually bring the price of AAPL down. You are hoping for the Apple stock to go up but somebody, without your direct consent, has used your stocks to push down its price!!! If most stockholders are aware of this, they would stop their brokers from lending their holding to short sellers. They would not want someone to use their stocks to cause the damage to own interests. Any way, it is hard to change the system and let every brokerage account holder decide if they want to lend their stock holding to some short sellers. The point I am trying to make is: It should be government's objective to bring stability to markets. In normal stable markets, it is okay to allow short selling but when the markets are in panic, short-selling can prove suicidal to economy. Government needs to look at the share of short-selling volume to total trading volumes in the market. The volumes have currently dried up and in such thin markets, any short selling can be more suicidal to the company the short sellers are shorting, and to the company's employees, vendors, customers and the whole economy in the end. Some companies which can probably survive the current down-trend are being pushed in to bankruptcies by the money-minded actions of short sellers. I am just surprised to see that nobody is talking about ban on short selling in current market conditions.

(The article is work-in-progress. If you like it, please circulate it- not because I want to be famous but because I want to see a ban in short-selling in current market.)
Updates: Read here what Soros has to say: "..the underlying reality is that the markets not only passively reflect, but also affect reality, .."