Short selling: the bear's secret weapon

Professional short sellers are constantly causing a stir and prompting controversial discussion. And they occasionally step into the political and judicial limelight as well. We take a look behind the scenes of the small but highly elite bear market investment scene.

Jim Cramer's off-beat financial investing television program "Mad Money" has made him a cult TV star in the USA. Until 2001, Cramer himself could be found at the trading desk of the hedge fund company he founded and managed. The online interviews he gave on TheStreet.com's "Wall Street Confidential" were the cause of frequent controversy. In the December 22, 2006, edition, a ten-minute special showed Cramer chatting among other things about the questionable practices of short sellers who attempt to keep a stock's price down through market manipulation and using business journalists to influence stock prices. But it wasn't until the video surfaced on the internet in March that the interview caused a worldwide stir, reaching millions of people on "YouTube.com". In March, the online edition of the Frankfurter Allgemeine Zeitung also headlined with "Gerüchte für blöde Journalisten" (rumors for bozo reporters), quoting Cramer's descriptions of stock price manipulation, a practice that is apparently common in the industry.
In times when both sides of the Atlantic are busy discussing how and to what extent the growing hedge fund industry has to be curbed, stories like these fall on fertile ground and give those who tend to mention hedge funds in the same breath as plagues of locusts and robber barons plenty of ammunition. And Cramer's interview is doubly explosive, given that methodical and organized short sales are among those practices that politicians have always treated suspiciously, often taking it upon themselves to intervene swiftly.

The first "bear raid"

 The world's first ever "bear raid" was orchestrated by Isaac Le Maire in 1609: Le Maire, himself one of the largest shareholders in the Dutch East India Company, sold short the stocks of the trading company in a consortium with other speculators through forwards transactions. According to the Board of Directors, at any rate. Given the East India Company's falling stock prices, the Board of Directors approached the Staten-Generaal, the government of the Dutch Republic, with a petition in summer 1609. In it, the business magnates spoke of conspiracy, "unfair practices" and deceit, because the sellers had apparently sold a much greater number of stocks than they actually owned in order to buy them back later at a much lower price, having spread rumors that the company was experiencing difficulties. Such business, said the complainants, was "to the disadvantage of a large number of stockholders, in particular many widows and orphans who had been prompted to dump their stock because of the false rumors." Whether Le Maire and his consortium were actually guilty of the crimes detailed in the petition is historically unclear, even if the sources would seem to suggest that they were. By contrast, the reaction of the politicians is a fact: on February 27, 1610, the Staten-Generaal imposed a ban on the sale of stocks which the seller did not actually own (today, this practice is referred to as naked short selling), setting the delivery date for forwards transactions as "not longer than one month".

Unpatriotic practice

The history of short selling is littered with cases of state intervention. When news of the stock bubble leaked, where stocks in the British South Sea Company were reduced to nothing by 1720 and the bubble burst dramatically, it wasn't just a series of suicides that was triggered. A seldom talked about consequence was the ban on short sales in England (although it was by no means the short sales that had led to the collapse).
Napoleon described the practice of short selling as simply "unpatriotic". He banned the practice in 1802, the punishment being one year's imprisonment. The USA followed France's example in 1812, although the ban on short selling was lifted again in 1850.

Double standards

It's not just politicians, but indeed most people, who have a guilty conscience about selling something they don't yet possess. They consider such transactions as risky at the very least, sometimes even morally questionable. On the other hand, the same people wouldn't think twice about buying something that the seller didn't yet own: a new car that isn't built until it's been ordered; a book from Amazon that the dispatcher frequently doesn't have in stock; or a vacation including flight, where you can only hope that they will take place.Everyday futures contracts like these are hardly earth shattering and are long-established cultural assets - even in organized trading. The first futures markets for agricultural products such as rice or wheat date right back to 16th Century Japan or Antwerp, where the first forerunner to a commodity futures exchange was born in 1531. Here, futures contracts for wheat that hadn't even been sowed were concluded - classic short selling.On stock markets, by contrast, alarm bells begin to ring - even for many experienced investors - whenever the term "short selling" is heard. It triggers associations with dramatic price collapses allegedly caused by short selling, or memories of major hedge fund crashes somehow linked with the "covering of short positions". The "highly speculative" (if not "unscrupulous") short seller is a regular in the media, arousing public excitement.
What's behind this widespread aversion to one of the cornerstone instruments of the financial market? And why is it now not only completely legal but also necessary on virtually all developed markets?

Who's to blame if your house catches fire?

Moral arguments that continue to have an effect today were generally used to put a stop to short selling:To back falling stock prices is to bet on a socially undesired event (in contrast, incidentally, to a futures trader who speculates on falling oil prices). And, what's more, short sellers earn money whenever their "bad" forecasts come true, something which many people regard as reprehensible. They put the short seller's good fortune in the same moral box as speculating on the bad luck of others and confuse the cause with the effect. What they forget is: it's not the person insured who is to blame if his house burns down - apart from insurance swindlers, that is. Of course there are also cases of criminal short selling in the history of stock markets. In contrast to the world of stocks, nobody has ever seriously come up with the idea of banning fire insurance.

Classic short selling

Despite any moral misgivings, short selling has become accepted market practice on the developed financial markets of this world. The short sale of a financial instrument (whether stocks, currency or commodities) is essentially nothing but a purchase with the sign reversed and is necessary to ensure the market remains liquid. So how does a classic short sale of stocks work?
A typical short sale involves borrowing stocks and immediately selling them at their market price. Usually, the lender is the broker or bank. Ideally for the short seller, the stock price falls and he "covers his position" by buying the same amount of stocks at a lower price and returning them to the lender.
For example: we are skeptical about foo.com AG's future and are therefore expecting the price to drop. So we borrow 100 shares in foo.com from our bank and sell them for their current market price of EUR 40 (a total value of EUR 4,000). Over the next ten days, the price drops to EUR 36 and we decide to close out the transaction. We therefore buy 100 shares for EUR 3,600 and return them to our bank. The profit is EUR 400 or 10% of the invested capital - notwithstanding the transaction costs. So what's the difference compared with an investor who expects the stock price to increase at the same point in time and buys 100 shares? From a rational perspective, simply the result's mathematical sign and the assessment of the two traders of the future direction the market will take. Or maybe not...

Risk: theoretically infinite
Selling short involves risks that are either lower or non-existent with the traditional buy and hold strategy. Whereas the most a buyer of a stock can lose is his investment, the short seller's potential losses are infinite. Theoretically, at any rate. It is also possible for a stock's value to increase tenfold, whereas it is impossible for it to lose more than 100% of its value. Let's take a closer look at the example above: 100 shares each worth EUR 40 are sold short (EUR 4,000 revenue), then repurchased for EUR 400 each (EUR 40,000 paid) and the deal closed out. The result: a loss of EUR 36,000.
So any investor concerned about the extent to which his losses can escalate is advised to steer well clear of the stock exchange.

Costs: higher than when buying

Apart from the theoretically higher financial risk, the short seller has, for all intents and purposes, to reckon with higher costs and liabilities than the buyer of stocks. The intermediary of a transaction (broker or bank) will at any rate levy a transaction charge (which doesn't necessarily have to be higher than when buying stocks). What's more, he will - depending on the credit worthiness of the borrower - demand a high margin (generally between 20 and 50% of the stock price). And of course the lender will also be looking to make money. Which is why the short seller will have to pay interest for the duration of the loan (between 1.5 and 4% per annum) as well as any dividend distributions for the duration of the loan. The lender will also reserve the right to reclaim his stocks at any time.
Then there is the tax: short sales are generally subject to a country's standard tax on speculative profits or on income, irrespective of the holding period (in contrast to purchased stocks).

The dreaded "squeeze"

The worst case scenario involves the short seller falling into the dreaded short squeeze trap in extremely volatile situations. A short squeeze is where there are too many buyers on the market and too few market participants willing to sell. In such cases, the - for the holder of the short positions - already expensive stocks can suddenly rocket in price again in no time at all, leading to very painful losses. The danger of a short squeeze is minimal for standard stocks, but is much higher for less liquid securities from subsectors.

Resorted to by few professionals

The short sale of stocks is a strategy that few professional investors resort to, not just because of the huge risk involved. Hurdles in the structure of the markets also have to be cleared.
Firstly, the short seller who speculates on falling prices flies in the face of the statistics: rising markets are more common and upswings last longer than downswings.
And: whereas it is ludicrously easy to buy stocks, short selling is not an instrument that is immediately available to private investors in Austria or Germany, at least.
Consequently, there are only three groups of market participants who short sell more than occasionally: firstly, market makers and other professional traders, who need short selling as a tool for securing the liquidity of a stock; secondly, arbitrageurs, who exploit price differences - for example between two stock exchanges - and who frequently hold their short sales for a matter of minutes; and thirdly an elite group of people who short sell specific stocks simply because they believe the securities to be too highly valued. Frequently, they are long/short equity and dedicated short hedge funds. The latter are specialized exclusively in short selling and the well-known among them are as rare as pearl oysters. Why? Because only very few of these funds, which are primarily bought by institutional portfolio managers such as hedge funds of funds for portfolio diversification purposes, are able to rise to the particular challenges of this style of investment and only very few survive the prolonged bull markets such as those of the past four years. One of the elite club of short managers who have survived is James Chanos, founder and president of Kynikos Associates - a three billion dollar US hedge fund of the dedicated short type. Chanos gained international notoriety during the Enron scandal. He had already begun to short sell stocks in the energy company in the fall of 2000 and regularly pointed out - publicly as well - irregularities in the accounts of the company that went out with a bang in 2001. He made no friends in the process. But in the end, he was right. Chanos appeared on the investigation committee as a witness and also used his testimony to put straight the image of his sector: "Finally, I want to remind you that, despite two hundred years of 'bad press' on Wall Street, it was those 'unAmerican, unpatriotic' short sellers that did so much to uncover the disaster at Enron and at other infamous financial disasters during the past decade."

Cop of the markets

When you hear Chanos talk, as leader of an advocacy group for the hedge fund industry that aims to lobby policy makers at a time when hedge funds are under heightened scrutiny, you could be forgiven for thinking that short sellers are an extended arm of the financial police. Which in actual fact is one of the characteristics of the species: the most successful short sellers have an almost forensic ability to sniff out inconsistencies in company balance sheets. Enron was far from being the only case of creative accountancy to be uncovered - and duly exploited - by short selling experts.
Take Belgian technology company Lernout & Hauspie, for example: long before the NASDAQ-listed vendor of speech recognition software went bankrupt in 2001 and the company's founders ended up in court for falsifying the balance sheet, hedge fund manager David Rocker had pointed out several times that something was amiss. Rocker, whose Rocker Management had a portfolio worth in excess of one billion dollars, became the self-proclaimed "Cop of the Markets".

Short selling crusades

First he went head to head with the US e-commerce provider Overstock.com, stocks in which Rocker had sold short in grand style. Overstock filed a lawsuit against Rocker Management and research firm Gradient Analysis in August 2005 alleging that they engaged in unfair business practices. Overstock CEO Patrick Byrne accused the two companies of nothing less than conspiracy against Overstock.The lawsuit over alleged short selling of Overstock shares encompasses a raft of other claims, counterclaims, petitions to the Securities and Exchange Commission (SEC), investigations as well as stern political intervention. In addition to the companies already mentioned, Patrick Byrne's conspiracy theory also includes known financial journalists, prime brokers Goldman Sachs, Morgan Stanley and Citigroup, the Governor of New York and even the SEC itself. His sweeping attack has already gone down in US media history as the "CEO's Crusade", even though most of the proceedings are still awaiting a verdict.But the fact is: the price of Overstock shares continues to decline, losing around three quarters of its value since the fall of 2004. There are two cast iron rules for cases like these. The first: no organized short sale is capable of causing any sustained damage to the stock price of a healthy company. The second: if a company begins to shout loudly about outside attacks on its stocks, then it is very likely that the company has a deep-rooted problem.

Culprit or victim?

Owen Lamont, professor at the Yale School of Management, proved in his study "Go Down Fighting: Short sellers vs. Firms", (Yale, 2004) that we are talking about not only one of the most common rules of thumb, but also an empirically tried and tested one. In his extensive research paper, Lamont examined 327 cases of anti-shorting actions, in which 266 different companies were implicated between 1977 and 2002.
The companies' arsenal included a wide range of measures, which the Yale professor put into three categories:

1.) "Belligerent statements" to named or anonymous short sellers, where the companies complain - generally via press release - about unfair stock price manipulation by short sellers or about the spreading of malicious rumors.

2.) "Legal actions" such as requesting an investigation by regulatory authorities or lawsuits against short sellers or critics.

3.) "Technical actions" (whereby in this category the line to stock price manipulation is blurred) that are directly targeted at a price advance. Such actions are intended to impede or render impossible short selling, or to trigger a short squeeze.

Lamont examined the price trends of the relevant companies over the following three years by comparing the stock performance of the relevant instrument with that of the reference index. The result in short: "The evidence shows that when firms take anti-shorting actions, their stock returns are extraordinarily low over the subsequent months and years." And more precisely: in the year following an action against short sellers, average stock returns were over 27% down against the relevant comparison market, the cumulative fall over the following three years reaching as high as 42%.
Lamont's advice to investors: if such stocks cannot be sold short or if the risk involved is too high, then returns should be sought elsewhere.
Incidentally, the author did not originally set out to substantiate an already well known piece of advice to investors, but to test the following theory: short sale constraints can allow stocks to be overpriced. These stocks can thus have low future returns until the overpricing is corrected. Or, in short: impeding or making short sales impossible results in overpricing. Lamont believes that the results of his study clearly corroborate this assumption.