Nov 21, 2008

Did short sellers deserve the blame?

Much has been made of short sellers role in pushing the price of stocks down, and while there are probably cases where one firm was unfairly targeted, do short sellers deserve all the blame they've received for stock market declines? The Bloomberg graph below shows the S&P500 index versus the monthly NYSE open short interest over the last three years. Up until September 2008, the trend is obvious, that shorts increased while the index decreased. Now that many forms of short selling have been regulated or eliminated, has the market bounced back? Unfortunately not. Even though short interest dropped by 50% in October, stocks continued their decline. This is even more disappointing when one considers that to close out a short position, the investor has to repurchase the shares, leading to an increase in net buyers as short interest drops.

Academic research shows that increasing short interest is correlated with stock price declines and poor operating performance, so shorts are well-informed and help with price discovery. Short sellers may also be good at detecting accounting manipulations. Moreover, banning shorts may not do anything to boost stock prices, and in fact could have the opposite effect if removing short sellers decreases the liquidity of the market.

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