Demystifying Short Sellers in the time of GameStop

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So, recent activities around GameStop and Robinhood are all over the news lately, and there is a lot of bad information and misinformation being thrown around. Part of this is because some of the ideas “Are Complicated,” but part is also do to our inability to teach modern financial literacy (that’s on us- mea culpa), and the continued trend to look for scapegoats and the creation of simplified villians to blame problems when the endemic and systematic problems are complicated.

1. Short Sellers are not Evil

Short sellers actually provide fundamental services to the efficiency of the economy and market.

  1. Short-sellers provide insurance for investors
  2. Short-sellers help prevent recessions
  3. Short-sellers aid regulators in identifying fraud in poorly managed companies

How do short-sellers provide insurance?

When large funds like pension funds and the funds that are available in your 401k want to reduce risk in order to keep your retirement money safe, they have to enter into contracts for options – the right to buy or sell an asset. In a free and open market, that means someone has to be willing to sell them these options. If you need the ability to pay for insurance against the chance that the stock could fall, you need someone willing to sell you that insurance!

How do short-sellers help prevent recessions?

The biggest cause of recessions and depressions, throughout history from the Dutch Tulip Crisis (see: here) to the 2007-2008 Financial Crisis (see: here) are asset bubbles. Speculation drives prices up to the point where they don’t fundamentally match the value, and when most people realize it, prices crash. When prices crash, people have less spending power/income, lose their savings, stop buying goods and services, and companies have to reduce production – and that can mean only one thing, layoffs and unemployment.

Research shows that by helping prices reflect closer to their fundamental value, and by providing our insurance function, short-sellers help to (a) prevent recessions by preventing speculative bubbles, (b) reduce depth of recessions by making the bubbles smaller, (c) reduce length of recession by helping prices to adjust more quickly, and (d) provide a backstop for retirement and critical savings by dampening losses by providing price insurance.

In fact, the last two recessions were caused from things that couldn’t be shorted – the housing market is not an open and transparent market and is notoriously difficult to short directly (to stop the bubble), and 100-year event viruses are, I would argue, impossible to short.

How do short-sellers help identify fraud?

By focusing on investing long and companies that are well-managed, and shorting companies that are poorly managed, short-sellers often reveal fundamental deeper problems in corporate governance and illegal or fraudulent accounting practices.

Name a bad company that was public, short sellers were early on the call.
Short-sellers identify problems at Enron
Short-sellers and the Theranos fraud
Short-sellers uncover financial statement fraud
Short-sellers provide a faster time-to-discovery of fraud (Journal of Finance)

In fact, why wasn’t Bernie Madoff’s Ponzi scheme fraud uncovered by short sellers? Guess who was running a non-publicly traded company that couldn’t be shorted…

But I thought short sellers were evil?

At the end of the day, the only real enemies of short sellers are CEOs and management of companies that are poorly managed, OR, like in the case of Elon Musk and Tesla, have very high stock prices which are difficult to justify. Large corporations and firm management dislike short-sellers because it makes them work harder and be more honest, but from a main street perspective, short sellers take on large inefficiently run companies to keep their price closer to the fundamental value, and actually help the average person with a pension or 401k.

Experts agree – https://www.cnbc.com/2018/10/05/experts-including-warren-buffett–say-short-selling-can-be-beneficial-for-markets.html

To summarize, I’ll quote a research summary from the Committee on Capital Markets Regulation:

The academic evidence on the effects of short selling on our capital markets is overwhelmingly positive. Short selling improves the efficiency of security prices, increases liquidity, and positively impacts corporate governance. Historical bans and restrictions on short selling have proved to negate many of these benefits, to the detriment of overall market quality.

By the way, the GameStop closest to me is still closing. The company itself can’t do anything with a higher stock price. There are no employees saved. If actually could make their position worse – they can’t raise more capital for investment at these price levels. The recent investor, Ryan Cohen, who Reddit hoped would turn things around can afford fewer shares to gain board influence to improve management. And while everything is worth what people will pay for it… everyone knows GameStop is not worth what people are paying for it. Puts the company in a pretty bad position. As it stands now, investment in GameStop is effectively a Reddit Ponzi scheme that will end as soon as it runs out of Ponzi victims.

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