Buy low, sell high and you’re rich and everybody’s happy. Sell high, buy low and you may be rich but odds are that quite a few people are anything but pleased. That’s the short seller’s predicament, and why investors who bet that stocks will drop get threatened with everything from temporary restrictions to serious jail time, particularly during times of stock market turmoil. Shorts, as they're known, say they’re keeping markets and companies honest. Critics say their practices can blur into market manipulation. Some regulators are taking note.
The biggest headlines these days are being made by so-called activist shorts, even though they account for only a small slice of short selling. Most shorting is done by hedge funds and institutional investors to cushion their investments against falling stock prices (that’s called hedging) or to bet that shares have risen too high. Activists research companies to find targets that they allege have dodgy business or accounting practices, spread the word (sometimes anonymously) via Twitter and – if all goes as planned – watch the stock slump. Shares of Valeant Pharmaceuticals fell 40 percent on the day of a damning report by Citron Research in October. Although activist shorts have been crying foul for decades, their numbers are swelling thanks to the rise of social media as a platform for disseminating theories and analysis. In 2015, shorts began campaigns against 177 companies globally versus 119 in 2013, according to one accounting. The head of the U.S. Securities and Exchange Commission said in November that short selling was getting the agency’s “intense attention.” China’s regulator blamed “malicious” short selling in part for a stock market crash in 2015, placing limits on the practice as well as arresting traders and imposing fines. Even so, the practice is flourishing. In the U.S., bearish wagers reached the highest since the 2008 financial crisis last year, when stock markets in Hong Kong and Japan had unprecedented short-selling volumes. U.S. activists have targeted Japanese companies this year, prompting criticism from the stock exchange there. And in Hong Kong, Citron Research's owner Andrew Left was found culpable of market misconduct over a 2012 research report.
Short sellers borrow shares, sell them, buy them back at a lower price and profit from the difference — unless the stock rises. Dutch traders were shorting as long ago as the 1600s, including during the tulip bubble. Napoleon labeled short sellers of government securities “treasonous.” Short selling stocks — as opposed to, say, tulips — is particularly challenging because equity markets have a long-term track record of moving up rather than down. Still, it can be done. Jesse Livermore, known as the “King of the Bears,” made a fortune shorting railroad operator Union Pacific shortly before the 1906 San Francisco earthquake. The collapse of Enron in 2001 marked a notable scalp for shorts including Jim Chanos, who had been among the first to question its accounting. Carson Block of Muddy Waters raised the profile of the new breed of activist shorts by taking aim at under-the-radar Chinese companies listed in North America, including the now bankrupt Sino-Forest. When markets go bad, governments and regulators sometimes impose restrictions on short sellers in an effort to help stem the slide. The U.S. targeted short selling during the Great Depression and joined the likes of the U.K., Germany and Japan in limiting short selling or banning it during the financial crisis.
Critics say short sellers can transform downturns into full-blown panics. They point to the ability of shorts to hoodwink investors by spreading false rumors before exiting a trade, a technique known as “short and distort.” Defenders say the potential for abuse shouldn’t discredit all shorts any more than “pump and dump” schemes disgrace all investors who whip up interest in a stock to push it higher and then sell it. Short sellers say they are skeptics who alert investors to bouts of market euphoria, identifying mispricing or deception that analysts, auditors and investors overlook. The name of Chanos’s firm is Kynikos – the Greek from which the English word “cynic” was derived. Often vilified as market outlaws, short sellers are portrayed as the good guys in the film “The Big Short.” Shorts have some backing from researchers: One paper found that short selling discourages the manipulation of earnings reports, while another showed shorts making more accurate predictions of the share performance of U.S.-listed Chinese firms than stock analysts. A third concluded that activist shorts were usually “factually right.”
The Reference Shelf
- Activist Shorts Research tracks the most notable short sellers, comparing their bearish reports against the performance of their target stocks.
- Bloomberg columnist Matt Levine considers the role of short selling in stocks, housing and shrimp markets.
- Michael Lewis’s definitive take on the financial crisis — “The Big Short” — is also a movie starring Christian Bale, Steve Carrell and Brad Pitt.
- This study from New York University found that activist short sellers are usually right — more than a third of their targets were subsequently delisted.
- A 2014 study, The Invisible Hand of Short Selling, found short sellers have a disciplining effect on various types of corporate earnings management.
- A Bloomberg article on why Bill Ackman is one of the most famous hedge-fund activists in the world.
First published Dec. 21, 2015
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