Shorting has made it back into the headlines because a number of directors and financial commentators are seeking to blame it for the fall of civilization, or at the very least the fact that bank shares have taken a beating.
I wrote just over a year ago about how powerful forces will do whatever they can to skew the market to favor long positions. And so it has come to pass that restrictions have been introduced on short selling, first in the UK and then the US.
I can sympathize with the need for restrictions to some extent. If banks such as HBOS in the UK were allowed to go bust, the lost deposits and the need for tax-payers to refund people’s savings would drive economies into depression. There was also the suspicion that traders on the short side were spreading rumors to undermine the stocks they were shorting.
Financial commentators need to get things in perspective though. Short selling hasn’t destroyed the banks’ balance sheets and reputations. Bad management alone has done that. Short selling can merely accelerate the discovery process and bring to light the fundamentally poor risk management practiced by people who – given their enormous remuneration levels – should have known better.
It looks, though, that shorting didn’t actually have much to do with the situation. Take HBOS again. During the three-day price slump culminating in its takeover, 990 million HBOS shares were traded – that’s almost 19 percent of the stock. Yet figures from dataexplorers.com show only 3 percent of HBOS stock was on loan. (Fannie Mae and Freddie Mac at some stages peaked at 40 percent loaned.) So for UK authorities to blame shorting for HBOS’s predicament and then use this as the basis for trading restrictions seems a bit like blaming a mouse because a dog ate your supper.
I enjoyed the quote at the end of the week from SEC chairman Christopher Cox:
“The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets.”
In a rational world, we would of course apply the same high-minded approach during bull markets, when stocks are talked up rather than down and companies are able to fund takeovers of other companies using the value of their own hyped stock as capital. We don’t though. We allow these bull-market frauds to continue. They only seem to be exposed finally by falling stock prices. (These evil short sellers again!) Still, I shouldn’t complain too much; bull markets that continue for too long are easy to profit from, because you can simply sit on the trend for as long as it runs.
The week’s happy/sad events bring Jesse Livermore’s short-selling career to mind. Here’s what he had to say in Reminiscences of a Stock Operator about how he and others brought the market to its knees through short selling, and why he stopped selling and went long before he caused a country wide (not Countrywide!) catastrophe:
Things got worse and worse. Finally there came the awful day of reckoning for the bulls and the optimists and the wishful thinkers and those vast hordes that, dreading the pain of a small loss at the beginning, were now about to suffer total amputation without anaesthetics.
My friend’s partner was as bearish as I was. The firm therefore did not have to borrow, but my friend, the broker I told you about, fresh from seeing the haggard faces around the Money Post, came to me. He knew I was heavily short of the entire market.
I had seen a smash coming, but not, I admit, the worst panic in our history. It might not be profitable to anybody if it went much further. Finally it became plain that there was no use in waiting at the Post for money. There wasn’t going to be any. Then hell broke loose.
The president of the Stock Exchange, Mr. R. H. Thomas, so I heard later in the day, knowing that every house in the Street was headed for disaster, went out in search of succor. He called on James Stillman, president of the National City Bank, the richest bank in the United States. Its boast was that it never loaned money at a higher rate than 6
per cent. Stillman heard what the president of the New York Stock Exchange had to say. Then he said, “Mr. Thomas, we’ll have to go and see Mr. Morgan about this.”
The two men, hoping to stave off the most disastrous panic in our financial history, went together to the office of J. P. Morgan & Co. and saw Mr. Morgan. Mr. Thomas laid the case before him. The moment he got through speaking Mr. Morgan said, “Go back to the Exchange and tell them that there will be money for them.”
“At the banks!”
So strong was the faith of all men in Mr. Morgan in those critical times that Thomas didn’t wait for further details but rushed back to the floor of the Exchange to announce the reprieve to his death-sentenced fellow members.
Then, before half past two in the afternoon, J. P. Morgan sent John T. Atterbury, of Van Emburgh & Atterbury, who was known to have close relations with J. P. Morgan & Co., into the money crowd. My friend said that the old broker walked quickly to the Money Post. He raised his hand like an exhorter at a revival meeting. The crowd, that at first had been calmed down somewhat by President Thomas’ announcement, was beginning to fear that the relief plans had miscarried and the worst was still to come.
I heard a day or two later that Mr. Morgan simply sent word to the frightened bankers of New York that they must provide the money the Stock Exchange needed.
“But we haven’t got any. We’re loaned up to the hilt,” the banks protested.
“You’ve got your reserves,” snapped J. P. “But we’re already below the legal limit,” they howled
“Use them! That’s what reserves are for!” And the banks obeyed and invaded the reserves to the extent of about twenty million dollars. It saved the stock market. The bank panic didn’t come until the following week. He was a man, J. P. Morgan was. They don’t come much bigger.
That was the day I remember most vividly of all the days of my life as a stock operator.
That morning a broker who had done a lot of business for my brokers and knew that I had been plunging on the bear side rode down in the company of one of the partners of the foremost banking house in the Street. My friend told the banker how heavily I had been trading, for I certainly pushed my luck to the limit. What is the use of being right unless you get all the good possible out of it?
Perhaps the broker exaggerated to make his story sound important. Perhaps I had more of a following than I knew. Perhaps the banker knew far better than I how critical the situation was. At all events, my friend said to me: “He listened with great interest to what I told him you said the market was going to do when the real selling began, after another push or two. When I got through he said he might have something for me to do later in the day.
“When the commission houses found out there was not a cent to be had at any price I knew the time had come. I sent brokers into the various crowds. Why, at one time there wasn’t a single bid for Union Pacific. Not at any price! Think of it! And in other stocks the same thing. No money to hold stocks and nobody to buy them.
I had enormous paper profits and the certainty that all that I had to do to smash prices still more was to send in orders to sell ten thousand shares each of Union Pacific and of a half dozen other good dividend-paying stocks and what would follow would be simply hell. It seemed to me that the panic that would be precipitated would be of such an intensity and character that the board of governors would deem it advisable to close the Exchange, as was done in August, 1914, when the World War broke out.
It would mean greatly increased profits on paper. It might also mean an inability to convert those profits into actual cash. But there were other things to consider, and one was that a further break would retard the recovery that I was beginning to figure on, the compensating improvement after all that bloodletting. Such a panic would do much harm to the country generally.
I made up my mind that since it was unwise and unpleasant to continue actively bearish it was illogical for me to stay short. So I turned and began to buy. It wasn’t long after my brokers began to buy in for me and, by the way, I got bottom prices that the banker sent for my friend.
“I have sent for you,” he said, “because I want you to go instantly to your friend Livingston and say to him that we hope he will not sell any more stocks to-day. The market can’t stand much more pressure. As it is, it will be an immensely difficult task to avert a devastating panic. Appeal to your friend’s patriotism. This is a case where a man has to work for the benefit of all. Let me know at once what he says.”
My friend came right over and told me. He was very tactful. I suppose he thought that having planned to smash the market I would consider his request as equivalent to throwing away the chance to make about ten million dollars. He knew I was sore on some of the big guns for the way they had acted trying to land the public with a lot of stock when they knew as well as I did what was coming.
As a matter of fact, the big men were big sufferers and lots of the stocks I bought at the very bottom were in famous financial names. I didn’t know it at the time, but it did not matter. I had practically covered all my shorts and it seemed to me there was a chance to buy stocks cheap and help the needed recovery in prices at the same time if nobody hammered the market.
So I told my friend, “Go back and tell Mr. Blank that I agree with them and that I fully realized the gravity of the situation even before he sent for you. I not only will not sell any more stocks to-day, but I am going in and buy as much as I can carry.” And I kept my word. I bought one hundred thousand shares that day, for the long account. I did not sell another stock short for nine months.
That is why I said to friends that my dream had come true and that I had been king for a moment. The stock market at one time that day certainly was at the mercy of anybody who wanted to hammer it. I do not surfer from delusions of grandeur; in fact you know how I feel about being accused of raiding the market and about the way my operations are exaggerated by the gossip of the Street. I came out of it in fine shape. The newspapers said that Larry Livingston, the Boy Plunger, had made several millions. Well, I was worth over one million after the close of business that day. But my biggest winnings were not in dollars but in the intangibles: I had been right, I had looked ahead and followed a clear-cut plan. I had learned what a man must do in order to make big money; I was permanently out of the gambler class; I had at last learned to trade intelligently in a big way. It was a day of days for me.