A recent study by three University of North Carolina researchers indicates that market short sellers profit from their enhanced ability to discern publicly available information, not from market manipulation or insider knowledge.
Common wisdom is that short sellers, those market participants attempting to capitalize on the misfortunes of individual stocks, manipulate or shape negative information to their benefit. The study, reviewed here in the New York Times, and published here, reveals that short sellers are merely very astute and perform a very high level of due diligence. These “informed traders” do not merely time the markets and information, and therefore, obtain unfair advantages over other market participants. Rather, short sellers perform effective due diligence and often prognosticate future failure or scams.
The researchers looked for evidence that short sellers’ informational advantages were due only to timing and “inside information”, and looked for evidence of abnormal short selling ahead of news events in the U.S. over the 2005-2007 period. They found no such patterns, and noted that the “ratio of short sales to total volume is nearly constant around news events.” The researchers actually found that “there is a significant increase in short selling AFTER the news event” which indicates that the short sellers are trading on publicly available information.
Prior research studies indicate that short sellers, for instance, do not tend to trade before earnings announcements. Other studies found no evidence that short sale transactions concentrate prior to bad news events. These results tend to indicate that short sellers may have an “informational advantage” and are informed. The studies also “highlight the importance of looking at more than one news category in assessing short sellers’ behavior, and shows that the information content of news leaves room for traders with different abilities to process the information to arrive at different conclusions about the value relevance of the news.” The recent study contributes to the research by highlighting how short sellers come to enjoy this advantage.
The results indicate that “the public release of information presents trading opportunities for skilled processors of information, that is, when news is released, traders with superior information processing skills can convert this news into variable information upon which to trade…Those traders who show exceptional skill in converting such data into value-relevant information are rewarded with superior returns on event-driven trades.” Specifically, the study found that “short sellers tend to trade at the same time as other traders, and when they do not, they trade after other traders. These results suggest that short sellers do not anticipate news.”
The study’s authors conclude by noting that news stories containing earnings projections, analysts comments and ratings, earnings, joint ventures and product distribution reports were deemed newsworthy by short sellers, but that short sellers possesses an uncanny ability to process the information provided to them.
In our current environment, market regulators and the investing public excoriate short sellers for something they do better than anyone else: perform effective due diligence and reveal market manipulations or scams (think Allied Capital and David Einhorn as just the most recent example). Instead of punishing short sellers for their uncanny wisdom, the SEC and other regulators should be studying their investing styles and the due diligence they perform, as they are often more predictive of future failures and frauds than regulators or other market participants. The SEC, laughably, has become a parody of an effective regulator, especially after the Madoff, Sanford, and Allied Capital scandals.
Market participants should celebrate short selling as an exercise in self-regulation rather than manipulation. Anyone or anything that enhances transparency in a market opaquely unaware of its shortcomings should be promoted rather than punished. Our economy has lived through perhaps the greatest act of self-delusion since the Dutch Tulip crisis, yet many still disdain any attempts to enhance its transparency. Short sellers are but one, isolated bridge to a fair and self-regulated market.
