The Buzz

All markets and investing news all the time

Short selling bans won't stop bears

July 24, 2012: 12:37 PM ET

Banning short selling won't work. Market bears may hibernate for a bit. But they'll be back with a vengeance.

The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, and Abbott Laboratories, La Monica does not own positions in any individual stocks.

The European debt crisis is over! Italy and Spain have it all figured out! The problem isn't unsustainable debt loads, ineffective economic policies and a lack of competitiveness on the global stage. It's that evil short sellers are pushing down the shares of European banks just so they can make a profit.

Oy. We've been here before. Since the 2008 financial crisis, securities regulators around the world have waged fruitless wars on short selling.  The short selling bans in Italy and Spain are the latest attempt by sovereign nations to blame traders for their problems.

It makes no sense. Short selling, when done legally, is a healthy way for the market to regulate itself. There is nothing inherently wrong with betting that a stock will go down when the fundamentals for a company paint an unhealthy picture.

Short sellers, who borrow stocks and sell them with the hopes of returning the shares later at a lower price, were instrumental in highlighting problems at scandal ridden companies like Enron and Tyco in the early part of the "Naughty Aughties."

Shorts, as these bearish investors are known for, uh, short, also have successfully predicted recent earnings blowups at momentum stocks, such as Green Mountain Coffee Roasters (GMCR), watch maker Fossil (FOSL) and online restaurant reservation site OpenTable (OPEN) .

Related: The biggest short: Green Mountain bears rejoice

Brad Lamensdorf, co-manager of the Active Bear (HDGE) exchange-traded fund in Dallas, a fund that shorts individual stocks, said that countries which are banning short selling are actually shooting themselves in the foot.

Lamdensdorf noted that one positive from short selling is that investors do eventually have to cover their position by buying back the stock.  So short selling bans can backfire by taking away liquidity from a market in crisis at precisely the wrong time.

"Short selling bans do not help the market. In fact, it's dangerous. This is what happens when politicians are making rules without considering what goes on with experienced traders," he said.

The performance of stocks following short selling bans over the past few years bears (pardon the pun) this out. Just look at what happened to bank stocks in the final few months of 2008.  After the bankruptcy of Lehman Brothers and near collapse of AIG (AIG), the Securities and Exchange Commission temporarily halted short selling in several key financial stocks in mid-September 2008.  Here's what then-SEC chairman Christopher Cox had to say about the ban at the time:

"The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets. The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets."

That didn't exactly happen. As the chart below shows, bank stocks continued to nose-dive in the final few months of 2008. And they fared even worse than the broader market. So any argument about banning short selling to "restore equilibrium" rings hollow.

Maybe bank stocks would have fallen by more than 50% if there wasn't a ban on short selling? Not exactly a compelling argument to label the ban a success.

Short sellers don't gang up on stocks or sectors just because they want to prove a point like Randolph and Mortimer Duke in "Trading Places." (Turn the machines back on!) Shorts look at data and make reasonable predictions on how a company or group of stocks will do based on that data. That's not manipulation.

In the case of Europe, the shorts didn't create the debt problems. They didn't force European banks to lever up and become too exposed to problem nations. The shorts are just merely looking to capitalize on it.

Analysts with Brockhouse Cooper, a brokerage firm in Montreal, nailed that point in a report Tuesday morning. The analysts wrote that "short-selling is not the cause of the European crisis, it is the symptom." Like Lamensdorf, the analysts fear that unintended negative consequences of banning short selling will be lower trading volume and an inability for institutional investors to use short positions as legitimate hedges.

And in what can't be considered a good sign for Italy and Spain, the Brockhouse Cooper analysts pointed out that the U.S. is not the only country that has tried and failed to stop market plunges with short selling bans.

Related: Greece: Here we go again

According to the Brockhouse Cooper research, markets in Australia, Greece, South Korea, Spain and Japan all tumbled between 20% and 50% in the final three and a half months of 2008 -- despite short selling bans on all stocks. Austria, Belgium, France, Canada and Germany also joined the U.S. in banning short selling of financial stocks. Their markets all tanked too.

Until politicians and regulators find real long-term answers for the many problems in Europe, shares of banks and other public companies in Italy, Spain, Greece and other debt-laden nations may continue to fall. And it's not because short sellers are creating a self-fulfilling prophecy. Banning short selling only interferes with the action of free markets and is yet another sad example of how it's easier to point fingers than come up with solutions.

Writer's note: Today is the last daily installment of my column. Starting this week, my contributions to The Buzz will be on Tuesdays and Thursdays. I will continue to do daily Buzz videos, Best of StockTwits pieces and occasional bonus columns on big news days, like analysis of a jobs report on a Friday, for example. I will also remain an active presence (some might say too active) on Twitter. I want to thank all my loyal readers who've been e-mailing, tweeting and leaving comments since The Buzz began back in January 2008.

Join the Conversation
Fear & Greed
Sponsored by
About This Author
Paul Lamonica
Paul R. La Monica
Assistant Managing Editor, CNNMoney

Paul R. La Monica is an assistant managing editor at CNNMoney. He is the author of the site's daily column, The Buzz, and also tweets throughout the day about the markets and economy @LaMonicaBuzz. La Monica also oversees the site's economic, markets and technology coverage.

To view my watchlist

Not a member yet?

Sign up now for a free account
Stupid Stock Move of the Day
#StupidStock Moves of the Day! Ebola is scary. But airline sector sell-off is overly emotional. Nothing to suggest people will stop flying.
Powered by WordPress.com VIP.
Follow

Get every new post delivered to your Inbox.

Join 242 other followers