Short sellers short as stocks surge

Pedestrians pass the New York Stock Exchange in the Financial District in October in the Manhattan borough of New York.
(AP)
Pedestrians pass the New York Stock Exchange in the Financial District in October in the Manhattan borough of New York. (AP)

NEW YORK -- The skeptics on Wall Street have vanished.

As the stock market has surged to records -- unbowed by recession, pandemic or warnings of a dangerous bubble -- activity has dwindled to a nearly two-decade low for the traders known as short sellers, who make their money betting stocks will fall.

From small-fry investors to members of Congress, critics paint short sellers as merchants of pain. People around the world celebrated early this year when GameStop's stock suddenly hurtled higher, causing billions of dollars in losses for short sellers. Many called it a long-due comeuppance.

But academics and short sellers themselves say they provide an important service suited for just this moment: pushing back against stock prices that may be rising too high, too fast. Despite concerns about the pace of the economic recovery and high inflation, the S&P 500 has set 65 all-time highs so far this year, with the latest coming on Monday.

Some critics say stocks look overly expensive, with some broad measures of value close to historical highs. Fewer short sellers in the market means there's less selling pressure tugging downward on those prices. It can also mean fewer investors looking for overvalued stocks or ferreting out fraud.

"This is the thing that short sellers do, they lean against the wind," said Charles Jones, a finance professor at Columbia University's business school, who has researched short selling. "If you have short sellers who are not afraid to do that, you will not get prices that are too high or too low, which is what I think we want when we are allocating capital."

Jones' research of Wall Street in the late 1920s and early 1930s, for example, looked at a group of stocks that were particularly expensive to short, which discouraged short sellers from targeting them. They went on to have returns that were 1% to 2% lower per month than other stocks of similar size, suggesting that they had been overvalued.

When investors short a stock, they borrow the shares from someone else and sell them. Later, if the stock falls as the short seller expects, they can buy the shares, return them to the lender and pocket the difference in price.

MISPLACED BLAME

So it's no surprise that short sellers regularly get blamed for driving stock prices artificially low. During the 2008 financial crisis, a few days after the collapse of Lehman Brothers, U.S. regulators temporarily banned the shorting of financial stocks, fearing short sellers would undermine already weak trust in them and trigger a run on the system.

Nearly four years later, though, a study by a New York Fed economist and professors at Notre Dame suggested the ban did little to slow the decline in bank stocks, which fell anyway. The restrictions also gummed up trading for bank stocks, raising trading costs in the stock and options markets by more than an estimated $1 billion.

Shorting activity has been trending down since July 2008, a few months before that temporary ban. Then, it was nearly twice the force it is now, accounting for 2.61% of all the shares in S&P 500 companies. Just 1.35% of all the shares in S&P 500 companies were sold short in August, according to data compiled by FactSet.

The stock market's mostly relentless rise since 2009 has prompted investors to pull dollars out of short-selling funds, helping to thin the ranks of the contrarians. Why go short when everything is rising?

"You have to look at what is causing the market to reach all-time highs," said Carson Block, founder of Muddy Waters Research and one of the industry's best-known short-sellers. "It is most definitely not that humanity is at our all-time greatest state."

Instead, he said a big reason is the ultralow interest rates set by the Federal Reserve to resuscitate the economy. Those low rates have sent waves of cash into the stock market, and critics say they're pushing up prices indiscriminately and allowing weak companies to hold on.

FRAUD HUNTER

Block specializes in rooting out fraud, and one of his earliest victories came with Sino-Forest, a company that was once Canada's most valuable publicly traded forestry business. Block released a report in 2011 calling the company a "multi-billion dollar Ponzi scheme" that was overstating how much it had in timber investments.

The company ultimately collapsed in what an Ontario securities regulator called "one of the largest corporate frauds in Canadian history."

Short sellers have also been credited with helping to publicize financial practices at Enron and Tyco International, two of the biggest U.S. corporate fraud cases, in the early 2000s.

Of course, short sellers also get it wrong sometimes. Tesla was a favorite target for years, with short sellers betting founder Elon Musk's visions for the electric-vehicle company were overly grandiose. Tesla recently posted a record quarterly profit and is one of the few companies in the world worth $1 trillion.

Not all short investors are betting only on stocks to fall.

Consider Marc Regenbaum, a portfolio manager at the Neuberger Berman Long Short fund. Most of the mutual fund's investments do well when stock prices rise, but it reserves some of its holdings for shorter-term short sales.

Regenbaum acknowledges the frustration that comes after identifying seemingly good candidates to short and then watching their prices climb. A rising tide has sent nearly 90% of S&P 500 stocks higher over the last year. But he said he still believes shorting some stocks can help manage the fund's risk and offer steadier returns during turbulent markets.

"Everyone thinks of shorting as this element of speculation and making absolute returns, as opposed to hedging things out and offering a smoother ride for the underlying investors," he said.

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