Academic journal

As Wall Street soars, short sellers in short supply

A television screen on the floor of the New York Stock Exchange shows the Federal Reserve’s recent rate decision. As the stock market soars record after record, activity has slumped to an almost two-decade low for traders known as short sellers, who make money betting stocks will drop. . (AP Photo / Richard Drew)

NEW YORK (AP) – Wall Street skeptics are gone.

As the stock market hit record highs – undefeated by recession, pandemic or dangerous bubble warnings – activity fell to an almost two-decade low for traders known as short sellers , who make their money betting stocks will fall.

It hardly saddens anyone. From small investors to members of Congress, critics describe short sellers as dealers in pain. People around the world celebrated earlier this year when GameStop’s shares suddenly skyrocketed, causing short sellers to lose billions of dollars. Many have called this a long overdue comeuppance.

But academics and short sellers themselves say they are providing an important service right here: pushing back stock prices that may rise too high, too fast. Despite concerns about the pace of the economic recovery and high inflation, the S&P 500 has reached over 60 all-time highs so far this year.

Some critics say stocks look overpriced, with broad measures of value near all-time highs. Fewer short sellers in the market means there is less selling pressure pulling these prices down. It can also mean fewer investors looking for overvalued stocks or looking for fraud.

“This is what short sellers do, they lean against the wind,” said Charles Jones, professor of finance at Columbia University’s business school, who has researched short selling. . “If you have short sellers who aren’t afraid to do this, you won’t get prices that are too high or too low, which I think we want when we allocate capital.”

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

When investors sell a stock short, they are borrowing the stock from someone else and selling it. Later, if the stock falls as the short seller expects, he can buy the stock, return it to the lender, and pocket the price difference.

So it’s no surprise that short sellers are regularly blamed for artificially driving down stock prices. During the 2008 financial crisis, days after the Lehman Brothers bankruptcy, US regulators temporarily banned the short selling of financial stocks, fearing that short sellers would undermine already low confidence in them and trigger a crisis. system rush.

Almost four years later, however, a study by a New York Fed economist and professors from Notre Dame suggested that the ban did little to slow the decline in bank stocks, which have dropped anyway. The restrictions have also hampered trading in bank stocks, increasing trading costs in the stock and options markets by more than $ 1 billion, according to estimates.

Short selling activity has been trending down since July 2008, a few months before this temporary ban. At the time, it was almost double its current strength, accounting for 2.61% of all stocks in S&P 500 companies. Only 1.35% of all stocks in S&P 500 companies were sold short in August, according to data compiled by FactSet.

The relentless rise in the stock market since 2009 has prompted investors to withdraw dollars from short-selling funds, helping to narrow the ranks of opponents. Why cut short when everything is going up?

“You have to look at what is driving the market to historic highs,” said Carson Block, founder of Muddy Waters Research and one of the best-known short sellers in the industry. “It is certainly not that humanity is at our greatest state of all time.”

Instead, he said one of the main reasons was the ultra-low interest rates set by the Federal Reserve to jumpstart the economy. These low rates have sent waves of liquidity into the stock market, and critics say they are driving prices up indiscriminately and allowing weak companies to hold on.

Short sellers were also credited with helping publicize the financial practices of Enron and Tyco International, two of the biggest cases of corporate fraud in the United States, in the early 2000s.

Of course, sometimes short sellers are wrong. Tesla has been a favorite target for years, with short sellers betting that founder Elon Musk’s visions for the electric vehicle company were too grandiose. Tesla recently posted a record quarterly profit and is one of the few companies in the world worth $ 1,000 billion.