Value Of Short Selling

‘Canaries in the Mine’ Predicting Trouble at Companies

Short selling benefits investors in several important ways. Allowing short selling helps prices to adjust more quickly to new information, decreases the likelihood of price bubbles, and may lead to higher prices as investors gain greater confidence that the prices are fair.(32)

“When someone’s research or information leads them to negative conclusions about a firm, short selling allows them to communicate their less optimistic expectations to others and make a profit if they anticipate the direction the market will later come to agree with,” observes Pepperdine University Economics Professor Gary M. Galles. “That is, they profit only if they come to ‘correct’ conclusions before others. In the process, they benefit others by revealing accurate information sooner than would otherwise be the case, reducing the mistakes people would have made from relying on the less accurate prices that would otherwise exist.” (33)

That point is made by researchers (Ferhat Akbas, Ekkehart Boehmer, Bilal Erturk, and Sorin M. Sorescu) at Texas A&M University. “Our evidence suggests that short sellers act as specialized monitors who generate value-relevant information in the stock market” about “future fundamental value, especially for stocks with low institutional ownership.”(34) They show that short sellers’ “holdings, as reflected in monthly short interest reports, predict public news announcements, earning surprises, and returns. In this capacity, short sellers join the ranks of stock analysts, institutional investors, underwriters, auditors, and bank lenders, who have been shown to provide similar information-acquiring functions.”

Other research suggests that informed short sellers align a stock’s price with its fundamental value. According to work by Asher Curtis, of the David Eccles School of Business, and Neil L. Fargher, of Macquarie University, “short sellers . . . play an important role in aligning price with fundamental value.”(44) The professors reached that conclusion after finding that short selling “does not amplify unwarranted price declines….[S]hort selling activity following price declines is most concentrated in stocks that are overvalued.”

Galles also argues that short sellers enhance market regulation. “Short sellers who are betting their own money on being correct often uncover what regulators miss, as they did at Worldcom, Enron, Tyco, etc., showing themselves as more effective market policemen,” he writes.(45)