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Market Declines: Is Banning Short Selling the Solution?

Robert Battalio
Hamid Mehran
Paul Schultz

Abstract
In response to the sharp decline in prices of financial stocks in the fall of 2008, regulators in a number of countries banned short selling of particular stocks and industries. Evidence suggests that these bans did little to stop the slide in stock prices, but significantly increased costs of liquidity. In August 2011, the U.S. market experienced a large decline when Standard and Poor’s announced a downgrade of U.S. debt. Our cross-sectional tests suggest that the decline in stock prices was not significantly driven or amplified by short selling. Short selling does not appear to be the root cause of recent stock market declines.

Furthermore, banning short selling does not appear to prevent stock prices from falling when firm-specific or economy-wide economic fundamentals are weak, and may impose high costs on market participants.

Hat tip FT Alphaville

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Stock investors may take days to distinguish real news from noise, according to Federal Reserve Bank of New York.

This is especially true these days, given false announcements of bailouts, Fed interventions and rescues. They tend to cause fake short squeezes that temporarily spike markets, only to see them ultimately head lower.

To get a closer look of noise on markets, the FFRBNY studied how UAL’s stock moved in September 2008. At the time, a “six-year-old report on the company’s bankruptcy filing appeared online and was treated as a new story.”

David Wilson of Bloomberg has the details:

“UAL, which later became United Continental Holdings Inc., plunged as much as 76 percent on Sept. 8, 2008, in response to the error. While UAL’s loss narrowed to 11 percent by the close of trading, the shares fell the next two days before rebounding.

“Residual effects attributable to the false news shock” lasted for seven trading days, the researchers wrote this week in a blog posting on the New York Fed’s website. The effect is at odds with the efficient-market hypothesis, which holds that share prices reflect all publicly available data on a company.

To identify the time period, they estimated where UAL’s shares would have traded if the outdated report hadn’t surfaced. The projection was derived from the performance of the Standard & Poor’s 500 Index, the Bloomberg World Airlines Index and crude oil during the period. The posting by economists Carlos Carvalho, Nicholas Klagge and Emanuel Moench was based on a report they published in May 2009 and revised in June. Carvalho, who teaches economics at the Pontifical Catholic University of Rio de Janeiro, worked at the New York Fed when the research was originally done. His two co- authors are still there.

Given every twitch of the market over tales of EU/ECB action, German banks bailing out Italy, or anything related to Greece, it is interesting to see how traders behave relative to false announcements.

I always laugh whenever I hear anyone say eejit hack claim “No one saw it coming!”

This video — featuring a thinner, less gray version of your humble blogger — discussing the coming housing storm in 2005 gives lie to that claim.

The advice: Sell banks, Sell Home Builders, Sell Home Depot and Lowes.

Video is here

Carson Block of Muddy Waters spoke to Bloomberg Television’s Erik Schatzker about Sino- Forest earlier today.

Block said he is still short Sino-Forest and that he isn’t a “ninja assassin” who brings down stocks. He thinks of himself as someone who is “protecting investors.”

I don’t understand why, but I keep seeing portfolios strewn with Ultra-Short inverse funds. These are the ETFs that bet 2X and even 3X that major indices will go down. 20, 30 even 40% of some accounts are laden with these.

Please stop.

Eventually, the downside bet will be a moneymaker. Eventually. But if you make that Macro call even a few Qs early with a leveraged bet, the negative consequences could be severe. As I have frequently suggested, waiting for a technical signal prior to shorting is a much better approach than guessing.

Note that I have no problem with the concept or the use of these – but you must understand the risks and issues of using these very short term instruments. There is lots of slippage relative to the indices they seek to short, meaning lots of tracking error. But that is the technical reason for why these should be used sparingly, or as a hedge, and only for days and weeks — not years.

The more basic question is the foolishness of shorting strong indices running straight up — without any technical or timing signal, it is suicidal to guess when this all comes to an end.

It is one thing to miss opportunity sitting in Treasuries or cash; it is something else entirely to fight the tape, let the trend run you over, and argue with the market.

Unless you have a red “S” on your chest and wear a cape, do not step in front of a speeding locomotives . . .

I’ve been doing the slow burn on a very foolish article in Tuesday’s NYT Dealbook, about European Short Selling rules.

The author is somewhat clueless about shorting. He writes:

“Companies have long complained that short-selling can lead to stock manipulation. In the financial crisis, managers at Bear Stearns and Lehman Brothers accused large investors of spreading rumors that sent their prices plummeting and created liquidity problems for the investment banks.

At the time, several countries — including the United States, Britain, Germany and France — banned the practice for shares in certain companies. Since then, the bans have largely been lifted.”

Its hard to imagine that in 2011, a financial journalist could actually write something like that — it is a shockingly ignorant repeat of the false claims made by those insolvent firms. Beyond merely one-sided and dumb, it ignores the facts as they became known after the collapse, as the truth came out.

Yes, it is true, the managers of BSC and LEH made those accusations. But it is also true that both of these firms had insufficient capital levels, enormous amounts of leverage. massive exposure to sub-prime mortgages, vast derivative risks, and in the case of Lehman Brothers, regularly engaged in accounting fraud, $50-100 billions at a clip (via the infamous Repo 103).

Damn those short sellers for spreading rumors that were true!

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Source:
In Europe, an Effort to Shed Light on Short-Selling
AZAM AHMED
NYT, FEBRUARY 7, 2011

http://dealbook.nytimes.com/2011/02/07/in-europe-an-effort-to-shed-light-on-short-selling/

I know Whitney Tilson from our Street.com days. He is a smart guy, and a very good Value manager.

But like many value guys, he can be early (on trading desks, they call that “wrong”). In his January letter to investors, he discusses some of his recent shorts that have not worked out (see PDF below). I love any money manager that does that — fearless, honest, self-reflective — these are the traits of a person who won’t make the same mistake twice. (Good for him)

When it comes to shorting, many people are in the dark. It is more challenging to be short, subject to squeezes; the return max out at 100% — versus unlimited upside for longs.

Over the years, I have put together some rules for shorting. These are pretty broad and general, but they have kept me out of trouble when

Basic Rules for Shorting Stocks

1. Shorting Momentum names is dangerous: Unless you are Superman, never step in front of a speeding locomotive

2. Valuation alone is insufficient reason to get short a stock — History teaches us that cheap stocks can get cheaper, dear stocks can get more expensive

3. ALWAYS work with a pre-determined loss – either a physical or mental stop loss — Never leave yourself open to infinite losses

4. Fundamentals tell you WHY to short something, not WHEN to short it. ALWAYS have some technical confirmation before shorting. Make a short selling wish list, then WAIT for technical confirmation. (We use Money Flow, Short Term Trend lines, Institutional Ownership, Analyst Ratings).

5. It is tough to be a contrarian: During Bull and Bear cycles, the Crowd IS the market.

You have to figure out two things:
…a) When the crowd is wrong — Doug Kass calls it “Variant Perception”
…b) When the crowd starts to get an inkling they are wrong

At the turns — not the major trends — is where contrarians clean up.

6. Look for Over-owned, Over-loved stocks: 95% Institutional ownership, All buys or Strong Buys (no sells), and 700% gains over the past few years are reasons to put names on your short selling wish list.  (That is how my partner Kevin Lane found and shorted Enron and Tyco back in the 1990s).

7. Beware the “Crowded Short“– they tend to become targets of the squeeze!

8. You can use Options to either juice your short returns, or pre-define your risk capital (options)

That is my short shorting list . . .

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Here is Tilson’s Letter to Clients
T2-Partners-Jan-2011

“The Chinese delegation has said all week that there will be double-digit growth for years to come and the Brits have lapped it up. But the data doesn’t add up. We think we’ve experienced credit bubbles over the past few years, but China is the biggest. And yet the global economy is looking to China as not just a crutch but a springboard out of the recession. It’s crazy.”

-Anonymous hedge fund manager in Mayfair. England

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Fascinating article in the UK Telegraph about the increasing risk that China’s rampant “growth at any cost” poses to the global economy:

“There have been academics and analysts who have argued about the dangers of China’s economy overheating for some time. But for many, the fact that hedge funds, particularly those with track records on previous crises, are launching specific funds is the sign that the bubble is close to bursting.

One academic said: “Economists have contrarian views all the time. But these hedge funds have their shirts on the line and do their analysis carefully. The flurry of ‘distress China’ funds is a sign to sit up.”

More analysts are becoming bearish too. Last week, Lombard Street Research put out a note warning of China’s “already dangerously home-grown inflation”.

The analysts said figures showing the continuing boom in China were far from welcome: “On the contrary, Chinese policymakers have to slam on the brakes.” The financiers are warning that rather than depending on China as the prop of the recovery plan, Britain needs to be braced for another shock.”

My question is whether China’s central planners can circumvent normal market forces — or if they can keep the economy humming along for 20 years as they migrate 800 million people from the exurbs to the cities . . .
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Source:
Hedge funds bet China is a bubble close to bursting
Louise Armitstead
Telegraph, 16 Jan 2011
http://www.telegraph.co.uk/finance/economics/8261740/Hedge-funds-bet-China-is-a-bubble-close-to-bursting.html

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While bullish sentiment towards the equity market has rebounded sharply since the end of August, at least one group of traders is not feeling the love, especially when it comes to technology-related shares.

Based on recent data from the Commodity Futures Trading Commission, commercial traders (i.e., defined by the CFTC as those who manage their business risks by hedging in futures and options) now have their biggest net-short position in NASDAQ-100 futures in recent memory.

As the follow chart (courtesy of SentimenTrader) shows, the “smart money’s” track record when it comes to identifying tradeable short-term trend reversals is not too shabby.

Combine that with the fact that many hedge funds have major exposure to technology darlings like Google, Microsoft, and Apple — according to Goldman Sachs, the latter is a top 10 holding of 75 funds — and one could argue that you have the makings for a nice little rout.

I guess we’ll soon find out.

BNN speaks to Diane Brady. senior editor, Bloomberg BusinessWeek, and Barry Ritholtz, CE and director of equity research, Fusion IQ.

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Did I just smoke a fattie? I don’t recall . . .

Click for video

Headline : September 16, 2010 : Panel – Part One [09-16-10 12:15 PM]

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This looks better (sober). . .

Click for video

Headline : September 16, 2010 : Panel – Part Two [09-16-10 12:25 PM]

BNN speaks to Diane Brady. senior editor, Bloomberg BusinessWeek, and Barry Ritholtz, CEO and director of equity research, Fusion IQ.