Happy 4th of July!

Certainly hope everyone has a safe and happy holiday!

I've been reading about how the SEC is considering putting restrictions on short selling. Now it seems likely they will reinstate the uptick rule, a requirement that you can only short a stock after an uptick, but it made me start thinking about short selling.

I guess the more I think about it the greater problem it seems to be. Yes, short selling has been around for a very long time but the capability for short selling and the amounts involved have exploded with the growth of hedge funds. Its easy enough to find how much short interest there is on any individual stock but not as easy to see the amount of short selling in total. I did see one old chart that showed the amount of short selling increasing exponentially between the early 1960s and the early 1990s. Based on some more recent data, short interest on the NYSE was said to be about 4% of total shares which would support that the increase has continued.

So what about short selling? Short selling is a way to bet that a stock will go down without actually owning the stock. Yes, the stock will eventually need to be purchased to cover the short position and it can be a risky strategy but the other impact is that it has some impact on the supply and demand of a stock. Now, when the amount of short interest is negligible it can be absorbed by normal market conditions. The situation that concerns me is when short positions become a significant factor in the number of shares outstanding.

Assuming stocks reach a supply and demand equilibrium because the number of buyers and sellers at a particular level are approximately equal. You can increase the number of sellers by taking short positions. Now, the impact of this clearly depends on the amount of short sellers. Now the number of short positions is not spread evenly across all stocks. Certain stocks either because they have had recent run-ups or because they have some negative news, attract a great number of short sellers. In those situations they have a multiplier impact on the stock, meaning that more shares are on the market than would have been otherwise.

This increases volatility of the stock price. Now if you think of the stock market as something akin to a casino, this is OK. However, if you think the fundamental purpose of the stock market is to provide for a fairly orderly place to raise capital, it may not be a good thing. However, there are clearly times when short sellers become so numerous for a particular sector or stock that they endanger companies. Near the end of 2008 the SEC banned short selling of financial stocks for a 2 week period, Britain banned it for financial stocks for a longer period and Australia banned it altogether. Whether these actions helped or not may be debatable. There is also a theory that if a stock has a large short interest, it has a built in demand level since all these short holders will eventually have to buy the stock to cover their positions.

So what should the SEC do? As I said earlier they will probably re institute the uptick rule. Should there be additional restrictions? One possibility would be to restrict the amount of short interest that could exist on any particular stock. Since there are other ways to bet that a stock will go down or up, puts for example, is short selling a good idea at all? It is clearly a speculative position that generates fees for the brokerage. It does provide a way for hedge funds to "hedge" but do we care about that?

I'll wait and see what the SEC decides. I will say that with the amount of retirement funds tied up in the stock market, the American people don't want it to be a crap shoot. Prices should not be inflated, but selling shares you don't own is gambling, plain and simple. It may expose overvalued stocks or it may depress values below where they should be. Either way it is not an investment.