On Short-Selling

On Short-Selling

Although free markets find the equilibrium price between spot supply and demand, they are indeterminate towards establishing equilibrium outside this short-term scope. In the long run, supply, demand and the price level adjusts.

Trend trading creates hyperbolic market prices. That is a phenomenon that exists even without the advent short selling. You can look at stock chart after stock chart and see trading behavior quite clearly. People jump on the bandwagon. There is little rationale that correlates a stock’s trading price and its intrinsic value. Its price has very little to do with retained earnings, shareholder equity, assets, liabilities, book value, even expected future earnings. These two values behave asymmetrically as I have found that most stocks trade in a pattern disconnected to their basic fundamentals.

Trend trading behavior dictates that when prices continue falling, the natural response is to get out of the way. It creates a downward hyperbolic trend where prices fall exponentially until the price falls so far below its long-term trend line and/or intrinsic valuation. This phenomenon exists even without short-selling. When you add short-selling, the laissez-faire capitalists argue, it clears markets sooner - like when ripping a band-aid off fast it hurts less.

However short-selling doesn’t actually have that effect for several reasons. For one, the phenomenon known as hypothecation obfuscates the supply/demand dynamic. Short selling is supposed to involve borrowing someone else’s shares and selling them as if you owned them with the intention of profiting by buying them back at a lower price later. It implies locking those shares up so they are not available to the market until they are bought back. But this is not how it works under hypothecation. In reality the shares remain available. This appears to the market as more shares available for sale artificially pushing up supply.

In your basic supply/demand dynamic, hypothecation of short-sold shares can dramatically increase supply and therefore prices fall. When this phenomenon is added to an already existing downward trend, it serves to artificially fuel the downward momentum. The second problem with short-selling is that it’s too easy to leverage to zero. When a brokerage firm allows their clients to buy on margin, this creates leverage when used to buy shares – an important point is that it can be used to buy any shares. Moreover, in this scenario there is a finite amount of leverage that can be applied toward any stock whose price is potentially infinite. Remember, a stock price theoretically could go to infinity.

Whereas when leverage is used to short-sell stock, the stock price on the downside is finite at zero. In many cases the stock price of zero is more readily finite than the amount of leverage that can be obtained through re-hypothecation.

For example, if there are 100 million shares outstanding, and 100 million shares hypothecated and then sold short – because they are not locked out, there will soon exist 200 million shares – the original 100 million shares plus the hypothecated shares sold short. Eventually, those 100 million short-sold shares will be bought back and everyone’s happy right? No. In certain circumstances like what’s prevalent in today’s market, before that occurs the stock price will already have been driven to near zero with the stock in violation of its exchange mandated minimum price – this causing it to be delisted from the stock exchange. Coincident with that the company is driven toward declaring bankruptcy as companies typically float stock for emergency operating capital or use their stock as collateral for short-term debt obligations. A sub par stock typically cannot raise capital in the credit or equity markets.

The capitalists’ rationale is this: the market simply helped speed up the inevitable. However in most cases that just isn’t true without this additional hyperbolic momentum caused by the hypothecation and downside leverage.

In many cases, the short sellers operate under total secrecy and float false rumors that malign the company and destroy confidence keeping buyers out of the market until the rumors are proven to be false. By that time the stock price collapses under the panic selling making the false prophesy come true.

I like the analogy of a mob rushing a theatre full of people, borrowing their belongings, and then screaming “fire” shortly before locking them inside. In most cases the predators don’t even need to set an actual fire. In the mayhem and mad rush to the exit doors, fire is the least of their concerns as they trample over each other to death. The few who survive end up receiving their belongings, while the remainder becomes the mob’s treasure trove.