Don't Blame the Ref!

There are right ways and wrong ways to regulate any activity that generates externalities, and this includes short selling. The latest crackdown, while suboptimal (so what government action is perfect?), was overdue and a step in the right direction.

A few preliminaries are in order. First, speculative activity, including the short selling of securities, is a vital part of well functioning markets. There is nothing in inherently evil about short selling or those who participate in it. It is speculative activity and therefore a part of what is best understood as a game. Games have to have rules, and optimizing the rules optimizes the game. How do we know this? Consider a game like football or hockey, which entail, but are not all about, physical aggression. Would these games be better if we did away with rules that proscribe grabbing face masks, clipping or slashing? Only if one believes that the essence of the game is players inflicting violence on each other. (How about letting the players carry sharp instruments?) Some fans may feel this way, but most fans agree that such games are about much more than seeing people get hurt. Games that get out of hand may be exciting in the moment, but only for a while, and the whole sport suffers when the “reason for being there” heads in such a direction.

Watching the feds act last week reminded me of watching youth hockey years ago. The refs often exercised a certain latitude in enforcing the rules, as calling a game strictly “by the book” tended to inhibit the kids and make for a dull game. However, if there were a few “incidents” and it became apparent that grudges were forming and boiling over into potential brawls, they would get really “literal” about the rules and effectively (most of the time) rein things in. Adroitly enforced rules made for a better game then, and they certainly make for a better game, insofar as the game is about much more than make a few ruthless and well connected rich guys even richer, in securities markets today.

My biggest beef with what has seemed like lackadaisical non-enforcement is that as someone who has shown up every day for decades looking for stocks that have been beaten down, volume is information, so naked shorting is no different than trafficking in false rumors. What I mean by “volume is information” is based on the realization that we can’t kid ourselves about knowing everything there is to know about a company or its stock, so we have to make allowances. One does the best they can to learn as much as they can about a situation, but to presume that one knows all there is, I think that comes under hubris. So one learns to pay attention to how the stock acts. An abnormal amount, or just a lot, of buying or selling might mean that someone knows something important that you don’t. Or maybe not, but seeing a lot of activity contrary to one’s assessment of the situation should give one at least some pause. Most of the time, this means doing some more work, thinking things through again, perhaps making a few phone calls. Sometimes one comes up with “something they missed”, more often, the volume is just noise and one continues to march.

Where this gets problematic is when the mood of the Market is degenerating towards an extreme. This is because in the moment, extreme price action is caused not just by activity on one side, it’s a dearth of willingness to act on the other. I can look at a stock and say, okay, what I care about is where its at three years from now. Based on my research, the company is going to do just fine. I really ought to buy this stock, but I have to take into consideration whether or not other prospective buyers will remain rational and long term oriented, or will they all decide that the rumors are just plausible enough to “wait and see”. Being way too earlier is unpleasant but bearable when doing so with one’s own capital, but when doing so with someone else’s capital, the prospect of having to explain it is likely to be enough to tip the balance to “wait and see”. To the extent that such accountability affects so much of the money in the market, “wait and see” culminates in a dearth of buying interest that gets overwhelmed by whatever is hitting the market that day. And the Bears know it.

“Bear raids” have been a part of the great game of Buy Low and Sell High since it was all happening under the buttonwood tree. When they got out of hand and started doing damage that was felt beyond the confines of the arena, the referees had to step in and make it rational for the marginally informed (i.e., most of us, most of the time) to consider getting involved. That is where we are today. I am sure that with the passage of a few years, enough time for memories of the Panic of 08 to start to fade around the edges, the refs will lighten up a bit. For now, though, the quality of the game has been damaged and it needs to be restored.