Issues & Insights

Ignore The Populist GameStop Hype: Short-Sellers Are Heroes

EPIC, Creative Commons Attribution-Share Alike 4.0 International

Reprinted, with permission, from Real Clear Markets.

Back around 2007, investor John Paulsen began to feel skeptical about the viability of mortgage securities. Though demand for them was much greater than supply, Paulsen sensed that lending standards had plummeted so far that loan delinquencies were set to surge. The “third rate” hedge fund manager (that’s what those who covered him at top investment banks felt) proceeded to very inexpensively purchase insurance on mortgages. He was able to because the consensus in the marketplace was that he was very wrong.

As readers know, Paulsen was subsequently vindicated in 2008. Funny about the billions he made on his bet was that all-too-many looked askance at his remarkable gains. Paulsen was said to be profiting from the pain experienced by borrowers and lenders. In truth, Paulsen was a hero.

His major investment gains sent a crucial signal that lenders should shrink their exposure to home loans. Realistically billions were diverted from a form of lending that, at the time, was no longer viable. Translated, Paulsen’s billions helped avert what would have been a much bigger economic crash if the faulty lending had continued.

Paulsen’s story is a useful way to approach all the overdone excitement about GameStop. Without presuming to know the intimate details of the gaming retailer, all the talk that its soaring share price is happy evidence of the small investor striking back against big bad hedge funds who were short the company’s shares is patently absurd.

For one, it’s not very reasonable to suggest, as some do, that a collection of investors inspired by Reddit could routinely move markets; thus putting those allegedly awful hedge funds out of business. For those who think otherwise, they might attempt to make it their investing strategy to join the Reddit herd in the future.

That’s the case because the stock market is a lot more complicated than simple supply/demand, and huge demand surges resulting in soaring shares. The reason for this is that a company’s valuation as expressed through shares isn’t solely a consequence of share scarcity as much as it’s a speculation in the marketplace about all the dollars said company will earn over its lifetime. In other words, every public company would aggressively limit outstanding share count if it were the path to a tripling of its value. It’s not.

Back to GameStop, the alleged revenge that small investors are enjoying over hedge funds is rooted in a misunderstanding about short sellers. In this case, it’s said that a few hedge funds were short GameStop’s shares, the shares have surged as everyone knows, which means a few hedge funds are said to be collapsed.

The populists are cheering! Those awful traders will learn to never short again! Let’s wipe out a few more of these producers of misery!

Actually, if it’s true that a few hedge funds were wiped out by GameStop’s surge, it’s a reminder of how heroic hedge funds are in the first place. It’s a reminder that if they didn’t exist, we would have to invent them. Think about it.

There is arguably no riskier market move than to short a public company’s shares. In doing so, a public-company skeptic borrows shares in the marketplace, pays for the right to borrow the shares, then sells them. The investment or bet in being short is that the investor who is short will be able to re-enter the market, purchase the shares previously sold short, only at a much lower price. The profit is in the difference between the proceeds taken in when selling the borrowed shares versus the cost of buying back the shares borrowed. It’s a great trade…if it works.

It seemingly didn’t for some institutional investors who were short GameStop. Shares that were trading around $4 six months ago are now commanding somewhere north of $300. It’s a reminder of how incredibly risky it is to be short any public company. While your trade can make you money if you’re correct that the shares are due for a fall, the simple truth is that the downside to your short position is endless. See Gamestop price once again to understand this.

“Serves them right,” some will say. “Short selling is a seedy act whereby big investors attack an innocent company and drive its shares down to nothing. Maybe GameStop will serve as a lesson so that this vindictive form of trading ceases to exist.” Let’s hope not.

To see why, please re-read the last few paragraphs. A short seller borrows shares, sells them, and pockets the proceeds on the assumption that re-purchase of shorted shares will come at a cost that is less than the proceeds gained from the sale. Stop and think about this for second. Maybe a few. Short sellers are by definition buyers. In order for them to take profits on their speculation, they must re-enter the market and buy back the shares they previously sold.

Short sellers don’t drive down markets in vicious fashion as much as their presence as size sellers is a happy sign of growing buying power in size. Again, buying is an essential part of any short sell.

After which it’s time for everyone to get real. Prices are the way that market economies organize themselves. It’s through prices arrived at freely that retailers know which items to stock and which ones to not, plus it’s through share prices that those with precious capital to allocate know where investment is needed, where it isn’t, where it will be wasted (think mortgages back in 2008), and where it will be rewarded. Without honest prices in the marketplace, the economy and stock market would plummet.

Please keep this in mind as pundits make their silly arguments about GameStop’s price action signaling a shift of power away from hedge funds, and back to the little guy. Such a view isn’t true, plus it ignores the heroics of short sellers. They’re in truth price givers, and the economy couldn’t function without them.

John Tamny is editor of RealClearMarkets, Vice President at FreedomWorks, and a senior economic adviser to Toreador Research and Trading (www.trtadvisors.com). His next book, set for release in March of 2021, is titled When Politicians Panicked: The New Coronavirus, Expert Opinion, and a Tragic Lapse of Reason. Other books by Tamny include They’re Both Wrong: A Policy Guide for America’s Frustrated Independent Thinkers, The End of Work, about the exciting growth of jobs more and more of us love, Who Needs the Fed? and Popular Economics. He can be reached at jtamny@realclearmarkets.com.  

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8 comments

  • What is the qualitative difference between a short, who without disclosing his interest goes out and spreads lies, rumors and innuendos versus a CEO who exaggerates earnings, and dumps his stock before they are disclosed?

    • EXACTLY RIGHT! I hope the author feels ok spending the money he got paid by shilling for the corruptocrats on Wall Street who do specifically what you described. And MSNBC and Fox Business and the rest of the networks who allow this to happen should be sued into bankruptcy themselves since they require no disclosure from their “guests” about their own positions are beyond “we’re betting against the stock.” First off, they can never admit to being in a naked short position since it is illegal!

  • Nice explanation as far as it goes, but John you left out the naked short selling part, when the heroic shorters sell shares they don’t own and didn’t borrow. Heros? I don’t think so, more likely criminals. As are those seeking to crush the reddit/sub-redditers. Criminals who’ll never spend one day in jail. Bankruptcy is just a little bit of karma.

  • I don’t think the populist anger is targeted at short sellers specifically so much as it’s targeted against big players in general. If the populists could find a way to target big players who are not short selling, they would do that just as happily as they are targeting short sellers.

  • Here’s the problem with your analysis: Its one thing to short a massive industry, like housing CDOs. Its another to target a company with a 250M market cap.

    For the hedges to have lot so much money they had to be heavily invested in GME. They borrowed a large percentage of all the outstanding shares, then sold them. So, if you borrow 80% of the shares of a company, then sell them all in one big dump, you know what happens to the price of those shares? It tanks, because you’ve flooded the supply with it.

    Shorting isn’t just a market message as to the true value, it also, when targeting a relatively small company, erodes the value.

  • It is not a free market when big players have special advantages and are supposedly able to short more shares than there are outstanding. As a small trader that wants to short the market, if shares are hard to borrow at your broker you are unable to short. Whereas a large player can shop around to short stocks if they are willing to pay the high interest rate of borrowing. If the interest rate to borrow is 30% does the individual get a piece of the 30% interest rate when his shares are sold against his position? No, he doesn’t get bubkis, and most are not even aware it is happening. In a two way market a long holder could lend his shares to a pool of short sellers and collect an interest rate for doing so, similar to a covered call. But we know that Wall Street is anything but fair. We are told this is the way it is supposed to be and it will benefit us. Shorting is a noble cause, provided all market participants can share the benefit. BTW, if anyone knows, who does collect this interest rate by lending shares to sell short?

    • Color me ignorant, but it would seem that one could only “borrow” shares from the owners of those shares. Are we to believe that 80%, let alone 102%, of the shareholders agree to lend their shares? Or is somebody collateralizing something they don’t own and lending these to the shorts? And if these shorts have borrowed the shares, how can anyone else then buy them?

      I’m afraid I know the answer, but maybe not.

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