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Monday, 10 August 2009

Short people aren't gonna get you every time

Hats off to Xiaoxia Lou of the University of Delaware and Jonathan M. Karpoff of the Michael G. Foster School of Business at the University of Washington, who have just published a report on short selling that you can download here.

It seems that according to the authors, short sellers are not the villains that politicians and regulators would have us believe. They say that listed companies are often inclined to inflate their reported profits with accounting mischief, and I would concur with that. Look at the accounting tricks posted by RBS and Barclays reported here last week for evidence, and in corporate America the practice is not restricted to the likes of Enron and Worldcom.

The authors identified firms that misrepresented their financial statements, the spotting of that overstatement of profits and share price declines until the time when the accounting treatment is widely known. According to the authors, uninformed investors who trade during the average firm’s violation period benefit from lower prices to the extent of ranges between 0.19% to 1.53% of the firm’s equity value.

They say that their research indicates that short sellers anticipate the eventual discovery and severity of financial misconduct. Short selling also conveys external benefits to uninformed investors, by helping to uncover financial misconduct and by keeping prices closer to fundamental values when firms provide incorrect financial information.

Somehow, I don't think financial regulators will be congratulating the authors on their report.


Demetrius said...

It probably explains many of the wails and moans about short selling. Could someone explain to me why short selling is so bad, yet short buying is so good?

Alex said...

Short selling is supposed to be bad for banks because a drop in share price can lead to a run on the bank's deposits, which leads to a vicious spiral. The reality is that there is enough rational money out there to stop this getting out of hand.

Steven_L said...

I found short-selling an interesting thought experiment when I first opened a cfd account.

You go short and you are hoping for bad news, you're waiting for the next report on unemployment and wanting hundreds of thousands of people to have lost their jobs so you can pocket a few hundred quid.

I managed to lose a few hundred quid in the end, but say I'd get lucky and made a load of money shorting stuff last year, I reckon it would have turned me into a right arsehole.