Market Commentary

As banking stocks crumbled and one-time trusted institutions collapsed there were many who blamed the calamity on irresponsible speculation and the demons of the moment - short sellers.  Because short sellers were seen to be profiting from falling share prices, they must so the argument went, have a vested interest in moving valuations downwards.  Unlike some of the more esoteric financial instruments around today, the ‘shorting’ of an asset is nothing new or unusual.  Although there are several ways to hold a short position, the basic principle works a little like this:

Imagine that you are going on an extended 3 month holiday.  While you’re away, you lend me the use of your house and I pay you a premium of £3,000 for the privilege.  I take a view that the value of property is going to fall over the next 3 months, so I decide to sell your house while you’re away, which I do for £300,000.  Of course, if I don’t buy your house back before you return the chances are you’ll be very cross, but in this instance there isn’t a problem because I’ve correctly called the direction of property prices and I’m able to repurchase your home for the lower price of £250,000.  You have your home and the £3,000 premium I paid you, while I pocket £47,000 profit – we’re both happy.

Of course in practice, property is far too illiquid to short as in the example above, whereas, a share is much more practicable.  In fact shorting creates liquidity in the financial system, as in order to ‘cover’ the short position (buying back the house in our example above), one has to not only sell a stock, but also repurchase it later.  Shorting is an effective way of moving capital around the financial system.

Short selling is often used by portfolio managers to control volatility within their portfolio because it allows them to generate some return even if the direction of markets turns against them.  It is interesting, therefore, to note that since the ban on the shorting of financial stocks was imposed, we have witnessed two things.

First, banking and financial stocks have continued to slide.  Second, volatility has increased.

It’s seems unlikely that the politicians, regulators and sections of the media who are blaming short selling are unaware of the reality.  Far more likely is that the notion of the profit hungry speculator, ruthlessly hounding a company, its employees and pension scheme to the dogs is a powerful and expedient image.

In times of woe it’s easy to find a scapegoat, convenient even.  In the same way that it’s convenient to take the credit for an economic boom, only to blame it on greedy bankers when the house of cards collapses.  The truth is that the culpability for the current financial crisis lies across the system, including the regulators and governments.  It is likely (desirable even) that there will be greater regulation of the banking sector in future, but this should be a considered response and not a knee jerk reaction.  Despite the position we’re in today, the record of governments in managing economies is no better than that of the market.