Exonerating the Shorts

Interesting discussion by the always worth reading Mark Hulbert about a recent research paper on Short Selling.

While I agree with the paper’s conclusion, it overlooks two major related issues regarding short selling.

Let’s look at a few excerpts first:

“Short-selling became particularly controversial during the recent bear market, when many of its practitioners turned a profit while almost all other investors were suffering. This fueled long-held concerns that short-sellers might be inducing the very price declines from which they profit. A series of regulations have been imposed in the last few years to restrict short-sellers’ behavior.”

This reflects the classic Keynes aphorisim that “It is better to fail conventionally than to succeed unconventionally.” Short selling has always been controversial for that exact reason. The small minority who makes a profit when everyone else is panicking into giant losses are always looked at askance.

On a related note, it also has given cover to dishonest management. I have never forgotten advice given me early in my career by a very successful fund manager: “Anytime management complains about short sellers, run-don’t-walk in the opposite direction. Its prima facie evidence of bad leadership — and a guilty conscious about something untoward at the firm.”

That’s been good, money saving — and in the case of Shorts, money making — advice.

So how do short-sellers find their trades?

“According to the new study, titled “How Are Shorts Informed? Short Sellers, News and Information Processing” — Its authors are Joseph E. Engelberg and Adam V. Reed, both finance professors at the University of North Carolina at Chapel Hill, and Matthew C. Ringgenberg, a Ph.D. student there. The study has been circulating since January as an academic working paper.

Their work suggests that the average short-seller has done well through astute research and analysis, not market manipulation.”

So far, so good.

Where I disagree with the paper’s results is in the statement “for the most part, at least, ‘short-sellers do not uncover and trade on information before it becomes publicly available,’ the researchers wrote.”

We know that is untrue in several high profile short situations. Jim Chanos discovered the fraud at Enron through forensic accounting. David Einhorn figured out that Lehman was playing games with their capital levels and cash ratios. Tyco, World Com, Bear Stearns, AIG, Fannie Mae were all high profile shorts that a small handful of people figured out were not what they claimed to be.

Perhaps the difference is psycholgical in nature. Wall Street research tends to cheerlead ore than it analyzes. Approaching analysis without that natural bias allows the discovery of errors and frauds The Street misses. This might be true even using the same publicly available information . . .

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Sources:
The Wisdom of the Short-Sellers
MARK HULBERT
NYT, March 26, 2010 
http://www.nytimes.com/2010/03/28/business/28stra.html

How are Shorts Informed? Short Sellers, News, and Information Processing
Joseph Engelberg,Adam V. Reed, Matthew Ringgenberg
University of North Carolina at Chapel Hill, February 22, 2010
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1535337