Interesting discussion by the always worth reading Mark Hulbert about a recent research paper on Short Selling.

While I agree with the paper’s conclusion, it overlooks two major related issues regarding short selling.

Let’s look at a few excerpts first:

“Short-selling became particularly controversial during the recent bear market, when many of its practitioners turned a profit while almost all other investors were suffering. This fueled long-held concerns that short-sellers might be inducing the very price declines from which they profit. A series of regulations have been imposed in the last few years to restrict short-sellers’ behavior.”

This reflects the classic Keynes aphorisim that “It is better to fail conventionally than to succeed unconventionally.” Short selling has always been controversial for that exact reason. The small minority who makes a profit when everyone else is panicking into giant losses are always looked at askance.

On a related note, it also has given cover to dishonest management. I have never forgotten advice given me early in my career by a very successful fund manager: “Anytime management complains about short sellers, run-don’t-walk in the opposite direction. Its prima facie evidence of bad leadership — and a guilty conscious about something untoward at the firm.”

That’s been good, money saving — and in the case of Shorts, money making — advice.

So how do short-sellers find their trades?

“According to the new study, titled “How Are Shorts Informed? Short Sellers, News and Information Processing” — Its authors are Joseph E. Engelberg and Adam V. Reed, both finance professors at the University of North Carolina at Chapel Hill, and Matthew C. Ringgenberg, a Ph.D. student there. The study has been circulating since January as an academic working paper.

Their work suggests that the average short-seller has done well through astute research and analysis, not market manipulation.”

So far, so good.

Where I disagree with the paper’s results is in the statement “for the most part, at least, ‘short-sellers do not uncover and trade on information before it becomes publicly available,’ the researchers wrote.

We know that is untrue in several high profile short situations. Jim Chanos discovered the fraud at Enron through forensic accounting. David Einhorn figured out that Lehman was playing games with their capital levels and cash ratios. Tyco, World Com, Bear Stearns, AIG, Fannie Mae were all high profile shorts that a small handful of people figured out were not what they claimed to be.

Perhaps the difference is psycholgical in nature. Wall Street research tends to cheerlead ore than it analyzes. Approaching analysis without that natural bias allows the discovery of errors and frauds The Street misses. This might be true even using the same publicly available information . . .


The Wisdom of the Short-Sellers
NYT, March 26, 2010

How are Shorts Informed? Short Sellers, News, and Information Processing
Joseph Engelberg,Adam V. Reed, Matthew Ringgenberg
University of North Carolina at Chapel Hill, February 22, 2010

Category: Research, Short Selling

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

17 Responses to “Exonerating the Shorts”

  1. to be clear, We’re not to come away with the impression that Chanos was receiving Telexes from Lay, Skilling & Co., correct?

    those boys, Chanos, Einhorn, et al., simply, did their own Research, yes? Instead of believing/hoping/praying that the MSM would be, other than, the: “Dog that did not Bark.”

    Gee, maybe they learned, as well, that ~”Free only means you’ve, already, paid for it, or, soon, will..”

    as ex., from a different facet “…information also gets disseminated with the help of fake (self-serving and self-funded) ’studies’ from the Gates Foundation, as we even mentioned last week. Suffice to say, such studies are likely to be flawed and here is just one new example…”

  2. V says:

    Approaching analysis without that natural bias allows the discovery of errors and frauds The Street misses. This might be true even using the same publicly available information . . .

    The “Who do you trust?” video of C. Gasparino and panel would demonstrate this to be true.

  3. dead hobo says:

    I admit to being afraid of the shorts once upon a time when I didn’t understand them or their true purpose. When their work is done honestly, they are more than invaluable. The pumps, scams, and bubbles would create even more phony valuation and fraudulent wealth without them running free.

    Having said that, shorts are as likely to steal as anyone else if you give then an opportunity. I’m not yet ready to immortalize them as majestic purifiers. Remember the naked shorts? Sell stock you don’t own in mass collusion or using conscious parallelism with others who sell stock they don’t own. Sell mountains of stock. Never even attempt to own or control it. Just sell it short. Then use a gullible media and hype a hysterical fear about something important. Just kill everything you can. Then, buy actual shares at a flattened price to the suckers who bought your first naked short. Repeat as required. Can’t be done? HFT, flash trading, co-location timing advantages, and dark pools do it on the upside on a daily basis.

  4. dead hobo says:

    I should proofread more. Usually I let the obvious ones go. This needs a fix:

    Then, buy actual shares at a flattened price AND DELIVER TO to the suckers who bought your first naked short. Repeat as required.

    I regret my inattention.

  5. Mr.E. says:

    The article is extremely interesting and consistent with prior work by others referenced in this new research. The new findings were based upon comparing short selling activity with news releases by combining two databases. From the paper,
    In this paper we address this question by combining a database of public news events with a database of all short sale trades, a unique combination that allows us to comprehensively examine the relation between short selling and the release of public information.
    I believe the point with which BR disagrees may be a matter of specifying what publicly available information gives rise to short sellers advantage.
    Some key findings of the research by Engelberg, et al :
    To examine whether short sellers’ informational advantage is due to timing, we begin by looking for evidence of abnormal short selling ahead of news events in the U.S. over the 2005 to 2007 period, a pattern that would be consistent with anticipation. We find no such pattern. … This result indicates that, on average, short sellers trade on publicly available information, that is, they do not uncover and trade on information before it becomes public.
    Given the finding that short sellers trade on publicly available information, we next explore whether short sellers’ informational advantage is due to their superior ability to process public information. … “Thus, a short seller’s most informative trades appear to be those in response to newly released public news, which is consistent with short sellers being good processors of information.

    This conclusion rather strongly suggests that any short sellers “advantage” is not a result of a “short and distort” strategy, but rather superior analysis. Further study to determine whether the apparent informed short trades were a product of either mistaken client buys offset by market makers short positions or clients with “superior information processing” concluded as follows:
    We find that clients’ trades are particularly well informed, and that these trades are much more profitable in the presence of news events. In contrast, market makers’ trades are not particularly well informed, and there is no differential impact in the presence of news. Overall, we conclude that the most informed short sales are from clients, and that these shorts are particularly well informed in the presence of recent news. This evidence lends support to the view that short sellers’ information advantage is due to their superior information processing ability
    A further analysis to determine which types of information are associated with the apparent short sellers superior information processing and resultant advantage, the paper reports:
    We find that short sellers’ most informative trades are concentrated in five categories: Corporate Restructurings, Earnings, Earnings Projections, New Products & Services, and Stock Ownership. Further, many of these categories correspond to the categories in which short sellers’ trades are measurably later than other investors’ trades, which lends additional support to the idea that short sellers’ advantage stems from superior ability to process publicly available information rather than an ability to uncover information before it becomes publicly available.

    My take is that this research confirms what we have recently seen – the winning short sellers are particularly astute at processing publicly available information, seeing through the smoke and obfuscation, taking a position on their belief and profiting from those positions as the rest of the story becomes clear to the broader public. In many cases those short sellers became very openly vocal about their findings, calling out the problems they identified, but usually only after they have been publically challenged. This is not to say that short-selling has not been not without its share of abuses (e.g., naked short sales). But that would appear to be a small part of the total picture.

  6. Marlinpat says:

    Dead Hobo: Why we don’t like and don’t trust Wall Street

    It’s in your last sentence:
    “HFT, flash trading, co-location timing advantages, and dark pools do it on the upside on a daily basis.”
    I have no idea what you’re talking about, but I have a feeling it has something to do with how the game is rigged.

    Shorting is ok. I thought better of it when there was a bounce rule in place, though Barry R. and others here more knowledgeable than I have said that’s not much of a check. Maybe it has something to do with the practices enumerated in your last sentence. Mr. Chanos, and others who through dent of hard research (if indeed THAT is true) ought to benefit from their insights and in the process do society a service. Personally, I believe naked shorting ought to be illegal, punishable by death.

    I’d prefer to see a shorting rule that requires the seller to have the borrowed stock certificates in hand, and read the serial numbers to the executing agent as he sells them. But then I also don’t think much of computer generated trading in milliseconds. We’d all be better off if things slowed down a bit.

    “Dark pools” – the mind reels.

  7. ZackAttack says:

    No matter how astute you are, you gotta have a pair of onions to hang on sometimes. The forces of the entire long-only world are arrayed against you.

    Timing is everything. Things always, always take longer than you’d ever imagine to fall apart. I had missed, shorting NCC in late 2006. I waited until my ears bled before I started shorting WM back in spring, 2007.

    Cramer goes on television and announces that WM is a buy-buy-buy, I guess around 45, because of its huge depositor base. Which, we now know, of course, was undergoing an electronic run. That quarter, Killinger steals from credit card reserves to symbolically bump the dividend by a penny. It was obvious in retrospect that WM was screwed, but you had to be wrong for months and months before it paid off.

    Meantime, everyone and his long-only brother was shooting against you. It’s a lonely road.

  8. l_emmerdeur says:

    George Papandreou is the latest example of “run don’t walk”. What’s he hiding? Well, for starters, he seems to be enacting austerity that targets the middle class and largely gives the rich a pass. The rich benefited from government largesse, bribe-induced sweet exclusivity deals, and large fraudulently-distributed EU loans, and now bear almost none of the burden of fixing the broken system they spearheaded in creating.

    This, of course, means that the Greek people, who, unlike Americans, tend to burn the country to the ground when they feel they have been wronged, will fight the austerity measures tooth-and-nail.

    Papandreou knows this. He knows austerity will fail, both due to resistance and because it will create a downward spiral of reduced GDP leading to reduced tax revenues leading to increasing deficits. He knows default is inevitable. And like the homeowners who don’t want to violate some nebulous moral code and walk away from their mortgages, he will waste precious time and money trying to stay above water before inevitably defaulting.

  9. GB says:

    I disagree that Bear Stearns was a “high profile short that a small handful of people figured out were not what they claimed to be.”

    They owned a large part of the subprime loans made late in the game “05-07″ vintage to catch up with the rest of the street. If the public (such as myself sitting on a pc) can make an informed decision that they had the most exposure to bad loans (not to mention AIG and Ambac with insurance) I have to disagree that it was a small handful of people.

    If the handful of people you are talking about knew the exact timing of when this would all fall apart then I must say that it’s a unique short. I myself timed it a few months wrong with puts.

  10. The Window Washer says:

    Do not pay attention to this post, it’s just a sith lord clouding your mind!!!!!!!!!!!
    Byrne started his sith lord theory in aug 05 apparently, how has Overstock done since then? “Run for the exits when management starts complaining about short sellers” is without a question the easiest investing rule ever. Print it, put it on the wall.

    Dead Hobo,
    No I don’t remember “the Naked Shorts”, where are all the big documented trades? No rants now. ” mass collusion” I guess it needs to be a whole bunch of brokers doing these trades for clients in numbers that move the market. Who and where?

  11. [...] How short-sellers add value.  (NYTimes also Big Picture) [...]

  12. scharfy says:

    Shorts and their ilk cannot, and do not, attack healthy prey. Think national geographic.

    They may attempt to execute a weakling by mounting attacks in various ways, but shorting NEVER (and I never say never) has NEVER ever taken down a healthy company. They scan the landscape for easy prey in the bottom 5% of the natural habitat. Leverage and lying are what they look for. Who needs that anyhow?

    These short sellers are closer in psychology to wild hyenas than Dr. Evil. Necessary part of the financial ecosystem – without whom the jungle would be an infected mess of sick animals.

    Heroes? No. Vital? Yes

  13. DL says:

    When it comes to crude oil futures, the politicians adore the short sellers.

  14. philipat says:

    I have never forgotten advice given me early in my career by a very successful fund manager: “Anytime management complains about short sellers, run-don’t-walk in the opposite direction. Its prima facie evidence of bad leadership — and a guilty conscious about something untoward at the firm.”

    That’s very wise advice. The only advice I got early in my career was “You need to learn how to fall asleep with your eyes open and how to take the credit for the work of others”


  15. mickeyc says:

    As someone who was short all the companies you mentioned, I am very puzzled by your conclusion. If you mean by “not publicly available” that CNBC wasn’t telling people to go short, then sure, the info wasn’t publicly available. If you mean the info was somehow hidden to people with an interest in finance and the time to do some basic research, then your conclusion is wrong.
    I am not a financial genius and did not independently work out that these companies were going to die by myself. I have also never been short a company that has not subsequently experienced severe problems.
    I have read and re-read this piece because I assumed I must have misunderstood your point (the grammar and spelling are a little wild which doesn’t help!).
    As an aside, my only short to ever lose money to date has been AIG! When it kept strengthening while other insurers dived in 2008 I became concerned the data I had looked at was wrong and I bought into managements confident portrayal of its cash position. This was during the only time in my life I watched financial television for a few months – lesson learned.

  16. [...] – Short sellers deserve some vindication, especially for uncovering dishonest management, Barry Ritholtz says. [...]

  17. [...] Sellers, News, and Information Processing, an academic paper recently picked up by the NYT and Barry Ritholtz. As the paper argues: The financial crisis has also been linked to the timing of short sellers’ [...]