Short on logic

I beg the indulgence of regular visitors as I return to a favourite topic: the iniquitous practice of short selling in equity markets, which I last addressed in a posting called "Get Shorty!", as recently as July 24.

The past week's wild gyrations on global stock markets must surely have put paid to any lingering suggestions that modern capital markets are anything more than a casino. The idea that there can be anything rational about the DJIA successively rallying and falling by hundreds of points, day after day, can no longer be sustained. It's hardly surprising that regulators should try whatever measures they can to protect their real economies from the madness. Here in the UK, for example, Lord Myners wants something done about so-called high-frequency trading, which uses computer algorithms to generate prodigious numbers of trades every second. It's estimated that such trading accounts for at least 50% of all activity on the London exchange, and percentages on US exchanges seem to be even higher.

Responding to wild, rumour-driven swings in bank stocks, France and three other European countries have resorted to something more old school: a temporary ban on short selling of financial stocks. As usual, this measure has prompted scornful reactions not only from financial markets themselves, but from a surprisingly wide range of media commentators. (See, for example, the normally sensible Jeremy Warner in the business pages of The Daily Telegraph. You'll find Lord Myners over there as well.)

Let's just go through this again. Investors have a perfect right to fall in and out of love with stocks. If you decide you don't like a particular stock that you own, you can try to sell it to someone else who sees things differently; conflicting opinions of value are the basis of every trade. But short-selling allows you to try to make profits out of something you don't even own, at the expense of legitimate sellers and innocent bystanders. Contrary to the claims of its apologists, there's no way that this activity adds anything to the efficient functioning of markets. When it's combined with rumour-mongering, as seems to have been the case with French bank shares this past week, it crosses the boundaries of the merely under-handed and becomes outright malevolent and immoral.

One of the business news networks concocted a graphic this week that purported to show that short selling bans don't even work. Using data for US stocks when such a ban was imposed at the height of the financial crisis in 2008, it appeared to show that over the following two weeks, the overall market was down 18% (if memory serves), while financials, covered by the short selling ban, fell by 23%.

It is, of course, not possible to test a counterfactual, but recall that at the time of the Lehman Brothers failure, there was a wholesale flight from financial stocks. Nobody attempted to stop those who owned bank shares from selling them, so it's not surprising that they fell more than the broader market. But it's surely reasonable to posit that the ban on short selling prevented gleeful speculators from making the carnage immeasurably worse, which is exactly what it was intended to do.

In the case of the French banks, the shares have actually rallied since the ban on shorting was imposed, which tends to suggest that all of the earlier selling pressure came from short sales rather than from longer-term investors lightening their positions. (There would also have been some short covering, but this would probably not have been enough to push the stocks higher if there were any serious underlying selling pressure).

In the UK this week we've heard a lot of moral outrage about rioters and looters, and a surprising number of commentators have drawn comparisons with the behaviour of expenses-fiddling politicians and amoral investment bankers. A lot of this has been well over the top. All the same, if you were to ask me to make a moral distinction between a rumour-peddling short seller and a youth selling a stolen i-Pad on eBay, I have to admit that I couldn't put a cigarette paper between them.