Short selling, as anyone who plays in the arena of the stock market should know, is all about borrowing somebody else’s stock, selling it in the hope that the price will drop, and if it does, buying it back, and pocketing the difference and, of course, returning the stock to its rightful owner.
For some reason, this attitude is considered by some to be downright un-American, and should be banned – especially if you make a profit. Of course, if you get “squeezed” because it went in the opposite direction, then, well, you just got what you deserved, say these folks. And the sky’s the limit as far as the extent of your loss, and you will just have to buy back and replace the borrowed stock.
There is a decided bias on the part of the government to encourage investors to only be “long” the market.
Today’s investors are constantly reminded of this fact, especially by none other than the taxing authorities who actually discourage short selling by banning it as a practice on tax-deferred pension accounts. I am told that if you try this, you will be taxed on profits, cannot offset losses, and will be taxed on those same profits again upon any distribution, and possibly risk the continued legal status of the account. Given that the average business person is probably investing his own investment funds via a tax-deferred account, perhaps aggressively, he is bound to the long side of the market.
And now, we have President Bush himself advocating that the small investor should get involved with the stock market, long side only, of course, with his Social Security reforms in mind.
Is there a danger to this built in bias, and if so what is it?
Panic, in a word.
We know about 1929, and more recently, we remember 1987. And the panic resulted in what is called “forced selling”.
At one time it was the holders of large almost unlimited margin accounts, as in the twenties (perhaps old Joe Kennedy knew this back in 1929, when, it is said, he was short of a lot of Chicago’s Yellow Cab stock, and rode the market down to the bottom, and lay the foundation for his family’s bullish prospects.)
In the eighties it was said to come from mutual funds, where the holders were taking out their money faster than the funds could sell their stock.
Now I believe the danger is from pension fund holders, forced to cash out because the value of their holdings has dropped dramatically and they need the money, and they didn’t or couldn’t hedge their bets.
If this is true, and it is demonstrably true, it should be obvious that stocks stop dropping when buyers come in. Of course these buyers could be the “smart money” who got out when the going was good, and now see an opportunity.
But the buyers will also be, in great numbers, those short sellers who have to buy in, whether they like it or not, and thus help to provide the cushion needed.
I believe one should try to separate oneself from any idea that one side is better than the other. To that end, I like to up-end my charts, and look at them with fresh eyes from the opposite direction as though everything is on the long side (a bit tricky these days where it’s all kept on a computer!)
And then set aside funds to hedge or play the short side outside of the pension account, a place where nobody can complain. And think about purchasing put options, where the risk is not unlimited.
The very patriotic investor can still stand tall, in the knowledge that, as you say, he or she is helping to prop up the market, buying back in, during a severe correction.