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Short sellers are being accused of making this bear market worse, but are they? It’s human nature to find bad guys to blame, and short sellers are easy targets. What could be more objectionable than traders who bet that stock prices will go down even more?
I differ with this argument. There is no evidence that restricting short sales prevents the market from going down. At the same time, there is plenty of evidence that such restrictions impose many other costs on all investors.
Consider what happend in the fall of 2008, in the wake of the Lehman Brothers bankruptcy and the near-collapse of the U.S. financial system. Four days after that bankruptcy, as the SEC was banning short selling of financial stocks, then SEC Chairman Christopher Cox said that the move “will restore equilibrium to markets.”
Three months later, the Financial Select Sector SPDR ETF XLF, -3.59% was 44% lower than when the ban went into effect. Cox said: “Knowing what we know now, I believe on balance the commission would not do it [ban short selling of financial stocks] again. The costs appear to outweigh the benefits.”
This perhaps explains why the SEC hasn’t instituted any short sale restrictions in this most recent bear market — at least so far. But regulators are under pressure from some corners to do so.
Why do short sale bans ultimately fail? Matthew Ringgenberg, a finance professor at the University of Utah, said in an interview that the general consensus among academic researchers is that, just as Cox concluded in late 2008, “short sale bans do more damage than good.” Specifically, he said, studies have shown that while such bans do “nothing to arrest the fall in prices,” stocks for which shorting is banned have “worse bid-asked spreads and higher volatility.”
Uptick rule
Rather than outright bans on short selling, regulators in the past have imposed the so-called uptick rule, which prevents selling a stock short unless its last trade was higher than the one that preceded it. This rule was originally introduced in the U.S. in the 1930s, and was eliminated in 2007, within weeks of the bull market’s top prior to the Great Financial Crisis.
That coincidence led to no end of conspiracy theories that the elimination of the uptick rule either contributed to or even was the major cause of that punishing bear market.
A deeper dive into the data does not support those conspiracy theories. For example, prior to eliminating the uptick rule, the SEC ran a pilot program for several years in which the rule was removed for some, but not all, stocks. Many studies that compared the trading patterns of randomly chosen stocks in both groups failed to find any significant difference in returns or volatility, according to Adam Reed, a finance professor at the University of North Carolina’s Kenan Flagler School of Business.
One particularly revealing study focused on companies that posted negative earnings surprises. Such companies’ stocks usually fall precipitously, and you would presume that such stocks are especially vulnerable to so-called bear raids. But the presence or absence of the uptick rule made little difference to such stocks. The author of the study found no “evidence that prices of stocks subject to the [uptick] rule declined at a slower speed than prices of exempted stocks at times of stress.”
The bottom line? Much as we might like to blame short sellers for contributing to our losses, they are no more blameworthy than the rest of us. If you still insist on believing that short sellers did cause prices to fall further than they would have otherwise, perhaps you should actually thank them for giving you the opportunity to buy stocks at lower prices.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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