Wednesday, March 11, 2009

Washington Should Continue to Favor Long-Buyers

Instapundit links to Rich Karlgaard's Washington Should Stop Favoring Short-Sellers. (Before we get started, do not take my investment advice. While misery may love company, you certainly do not want to be that miserable ;-) Rich omits several details about shorting equities, so I'm mostly faulting him for errors of omission. Perhaps he just didn't know—it's been known to happen (see below). Rich writes:
For investors, the question is: Does it still work to bet against the popular mood? I think so, but the worm in this apple is bad public policy. Specifically, the cockeyed policy that has, since late 2007, tilted the investing playing field toward short selling. Good public policy should not side with either longs or shorts. Policy should be neutral.
I do not feel that the playing field is tilted toward short selling. Nor do I see how anyone could honestly claim that it was. More importantly, the current regulatory scheme favoring long positions is better than a neutral policy.

There are several policies tilting the market long. First, you cannot establish a short position in an IRA account. Second, you cannot short mutual funds. It's possible that part of the assets of a mutual fund could be used for short positions. However, the regulatory requirements make this unlikely. The regulations described here explain why:
The Investment Company Act severely restricts a mutual fund's ability to leverage or borrow against the value of securities in its portfolio. The SEC requires that funds engaging in certain investment techniques, including the use of options, futures, forward contracts and short selling, "cover" their positions. The effect of these constraints has been to strictly limit leveraging by mutual fund portfolio managers.
In other words, the people least leveraged in the recent economic implosion (elderly folks with IRAs bulging with mutual funds) were some of the hardest hit. Did I mention that mutual funds only trade at the end of the day? The price of a mutual fund is set when the market closes. This means that on days where the market loses 5% of its value, you cannot cash-out your mutual fund to avoid further loses. You certainly can't flip a mutual fund in your IRA to a short position in the hopes of recouping some of what you losed. For these reasons, I prefer ETFs to mutual funds.

Back to the long tilt of market policy... Third, short sales can only be "day" orders. This rule was imposed in the wake of last year's meltdown. When placing a buy or sell limit order, you have to specify the duration of the order. The duration may be just for today (a day order) or good-til-cancel (GTC) which can be several months out. (Ok, there are a few others, but that would expose minutea that even I do not care about.) If you want to establish a short position in QQQQ (full disclosure: I'm currently short QQQQ) you have to place the order after the previous day's market close. You cannot simply enter that order on Sunday and review it the next weekend. This means that there's slightly more work involved in shorting (you have to enter your shorts daily).

Fourth, short interest is reported monthly and, if it's too high, there could be a short sqeeze. The short interest for QQQQ (153,801,007) is near the daily trading volume (173,147,912). That means that the days to cover is about 1. Combined with the good liquidity (high trading volumes), I believe the risk of a short squeeze is pretty low. Nonetheless, a squeeze would acrue to the benefit of the longs.

Lastly, if an equity you shorted pays a dividend, then you pay that dividend. If more companies paid regular dividends, there would be less short interest.

Karlgaard has three recommendations:
1. Suspend mark-to-market accounting
2. Make the SEC enforce its own ban against naked shorting.
3. Reinstate the short-uptick rule.
I don't think #1 is relevant to his argument. It would cause the firesale of a few banking concerns as companies would have to realize their paper loses. And, "suspending" it is a really bad idea. This market needs certainty and "suspend" is a word littered with temporal ambiguity. I'm not even convinced that mark-to-market is a bad thing.

Rich is spot on with #2. I don't know how the SEC can do this, but I agree.

I also agree with #3. In fact, I didn't know that rule had been remove—it's been known to happen ;-)

I will pick one last nit: Rich, if you want a "neutral policy" and the "short-uptick rule", would you also advocate a long-downtick rule? I would say no, because the market is not a zero-sum game. The policy should be appropriately biased towards longs.


Anonymous said...

I wrote an article on pjm as well on short selling. I am not against short selling, but favor an uptick rule.

I am active in the market as a professional trader. The opportunity for collusion among different funds to attack a companies stock is too great. This is why I favor an uptick rule. You can still short stocks outright in a futures market, an ETF, or in the options market.

There is enough arbitrage opportunities to keep the longs honest.

Even if funds don't collude, they can signal. I have seen it happen in stocks other than financial.

The cash equity market is a place where companies raise capital. It should not be used as a place to destroy capital with intent. If a company does poorly, enough long investors will sell the stock to keep it honest.

I admit, it's a difficult issue, but we lived with the uptick rule from 1938 to 2007, and I don't think we had any ill effects from it.

Stocks should trade in .05 increments as well.
Jeff Carter

dsm said...


I'm not too concerned about collusion. Doesn't each colluding party have an interest to stop colluding first? You're certainly closer to this sort of thing than I.

I absolutely agree that we need the uptick rule. I hope that wasn't unclear in my post.

I considered making your point about the equity market's main purpose being to raise capital for companies, but thought my post was already too long. I support the bias towards long positions.

I disagree with the .05 increments, because I think the smaller increments add liquidity to equities that trade under, say, $5. FWIW, I've had orders execute at fractions of a penny... I've always assumed that my order was bundled with a dozen others that averaged out to $12.7325, say, for me.