Saturday, 20 September 2008

Short Selling - Another mistake of History Repeated

Well the FSA and American authorities have decided to ban short selling. Again if we look back to what occurred during the Great Depression and take a look at Murray Rothbards book:

"As early as mid-July, Hoover returned to a favorite theme: attacking short-selling, this time the wheat market. The short-selling speculators were denounced for depressing prices and destroying confidence; their unpatriotic “intent is to take a profit from the losses of other people” - a curious charge, since for every short seller there is necessarily a long buyer speculating on a rise. When the crisis came in the fall, the Stock Exchange authorities, undoubtedly influenced by Hoover’s long-standing campaign against such sales, restricted short selling. These restrictions helped drive stock prices lower than they would have been otherwise, since the short-seller’s profit-taking is one of the main supports for stock prices during a decline."

"Short-selling was - and usually is - the chief object of attack by demagogues who believed that short sales were somehow fundamentally responsible for falling stock prices, thereby forgetting that for every short seller there must necessarily be a buyer, and also that short-selling accelerates the necessary depression - adjustment in stock prices. Senator Smith Brookbart of Iowa had, as early as January, 1930, introduced a bill to prohibit all short selling."

Again Murray Rothbard is spot on, as short selling helps shake out unhealthy business models from the system at an earlier stage thus helping the bust. He also states that investment firms make money from short selling to cover their long losses. I think an explanation of short selling is required.

Short selling is the process where by an individual looks at a company and thinks it is overvalued, thus borrows the stock from someone who is holding the shares in a long position. They usually use leverage as this increases the amount of money they can make typically putting down say 10% of the total stocks value they have borrowed. They then sell the stock at the current prices and wait for the stock to fall. For simplicity say they buy £100 worth of stock at £10 each. They put down £10 to borrow them and they fall by 50% or are now worth £50 at which point the short seller decides to buy them back and give them back to the long position they borrowed them from. That would be £40 profit or in percentage terms 400% profit, which shows how much money can be made from this however, what happens if the stock goes up? Well this is where it can be very painful. If the stock goes up 50% you may get a margin call from your broker asking for a further £5 to ensure at least 10% down. If you can't cover that amount, and the stock keeps going up you are effectively in real trouble. If the stock never falls you have to buy those stocks back at the new price of £150 meaning a loss of 500% from the original amount (as the £10 is included in the £100 original total that was borrowed). A lot of Investors did this for Freddie and Fannie, Northern Rock and other financial firms during the end of 2006, the start of 2007, as they looked at the balance sheets and saw, well a train wreck in motion, and profited from it a lot. The reason I mention leverage is most people who do short selling are hedge funds, pension funds, investment banks etc, the very banks this new law is supposed to be protecting. Yesterday the finance stocks shot up 50% - 70% - however much I didn't really look at the specifics, but they shot up. Now the law said short positions had to be closed out, which means that those investment banks could have lost a lot of money yesterday as they would have had to buy the stocks back at a higher price in order to hand back to the long seller. This is one of the reasons the financial stocks rallied a huge amount. Of course some of the short positions could have been from months ago, even last year, however I imagine a lot of them would have been put on quite recently after the collapse of Lehman etc. So the law that was brought in for financial stability has in fact in all reality inflicted more damage on the banks balance sheets, all to give the stock market a boost and to have artificial stock prices. Its another government and regulatory blunder and in the long run will lead to more stock falls further down the line.

I also noticed the FTSE and Dow rallied by huge amounts, with the FTSE gaining 431 points. This happens in markets, Bear or Bull. Its goes down 600, goes up 400, down 400, up 250 etc. Of course if we get inflation over the coming years which I suspect the stock market may go up, but whats the point if inflation is just pushing the price up. Its like having a savings account giving interest of 2% while inflation is 4% - a net loss. If we wish to keep the comparison with the great depression have a look of how the Dow performed.

As I said in my Next Great Depression post, the stock market fell but kept rallying. What point do you think we are at? Number 8 ... 16? However I would be surprised if the above was to be repeated as the Central Banks have already been priming the printing presses. It's going to get interesting that's for sure.

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