The recent short selling ban sparked a discussion between Peppercom senior analyst Matt Purdue and research analyst Milos Sugovic.
The Financial Times reports that the withdrawal of big traders in the financial realm in lieu of the ban could have a big impact on investment banks and increase market volatility.
Matt: Let’s not forget that the ban on short selling will artificially inflate the value of these financial stocks. And do we really want LESS transparency about these companies right now? Most short selling is seen as another piece of information a market uses to value a stock. Markets in general don’t like information gaps.
Milos: Here’s my two cents: Short-selling a stock you don't own increases its supply, driving the price down, in exactly the same way that buying a stock drives the price up. This effect is amplified especially in the aggregate. So a ban on shorting artificially reduces the “excess” supply and props up stock prices. No doubt about it.
But the fundamental question here is: is shorting really excess? The decision to short is based on short run expectations, and a ban on such speculation invariably introduces market imperfections. In effect, you’re not allowing the market to reach equilibrium via arbitrage due to asymmetries with regards to price, information, profit, etc. As a result, liquidity suffers.
Matt: The problem has been abuses by short sellers using rumor and innuendo to drive down share prices so they can profit from the decrease. That creates an excess of “hot money,” and there are already laws on the books to handle the spread of such rumors. But instead of actually taking the trouble to enforce existing laws, they dropped this bomb. It’s like using a nuclear weapon to get rid of termites in your basement. From a macroeconomic perspective, you can probably tell us what will result from the explosion.
Milos: When it comes to macroeconomic ramifications, standard macro theory emphasizes the effect macroeconomic fluctuations have on the stock market, and not vice versa, partly because the stock market is considered to be “random.” The link between stock prices and interest rates are not direct, but in general, you would expect stock prices to fall when interest rates rise, and vice versa. Similarly, stock prices and the inflation rate exhibit an inverse relationship, albeit a very loose one.
One interesting thing to think about is whether the ban is purely a response to current events or stage-setting for upcoming intervention.
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