Short Sales

Patrick Byrne, CEO of Overstock, was speaking on campus yesterday. I

went and listened. I'll probably have more to say about his talk on

another day.

For today, I'll say this. Patrick Byrne and I agree on at least one thing: Short-selling is a good thing. Now, Byrne is a well known critic of naked shorting, but he was clear to state in his talk that he's fine with short-selling as long as the person doing the short does so on a "pre-borrow" basis. This means that the person who shorts the stock has to arrange to actually borrow the share prior to the short.

So for today let's focus on what short-selling is, and why it's a good thing.

What is it? Let's start by looking at a graphic:

Amazon's Stock Price

Take a look at Amazon between 1998 and 2001. That's the period of the so-called dot-com-bubble. Technology stocks went way up, and then they went way back down.

Now suppose you were a super-smart market analyst, and you knew that the 1999 Amazon market prices were too high. How could you profit from this knowledge? The answer is that you could short the stock. To do this, you follow these steps:

1. Find somebody who currently owns a share of Amazon.

2. Politely ask if you can borrown their share.

3. Sell that share in the market. If, for example, you sold that share on April 16, 1999, you'd have received $95 cash from selling that share.

4. Wait.

5. Buy the share back at a later date, when (hopefully) the share price has fallen. If you bought the share on October 12, 2001, you'd have paid $8.

6. Return the share to the person you borrowed it from.

7. Pat yourself on the back --- you just made $87.

So that's what short-selling is: It's a way for people to profit when shares prices go down.

It often strikes people as odd that investors can profit when shares fall. Don't we all want share prices to rise? The answer is that if we hold stock, then we profit when shares rise in value. So in that sense we want share prices to rise.

But more generally, we want prices to be "right". That is, we want share prices to reflect the actual value (that is, net present value of cash flows) to be captured by the firm's shareholders. The reason is that people make decisions about what to do based on what prices are. And if the prices are wrong, the what-to-do decisions will be wrong.

Here's an example. In the summer of 1998, I was an assistant professor at the Kellogg School of Management at Northwestern. It's one of the world's top management schools, so an MBA from Kellogg is a really valuable stamp to have on your resume. But here's what happened that summer. First-year MBA students went away to their summer internships in Silicon Valley... and then didn't want to come back. We started geting phone calls from students --- and not a few such calls --- asking if they could defer their second year. 

The reason? Their dot-com internship employers were offering them hundreds of thousands of dollars to stay. Those salary offers were way in excess of what our graduates were being offered only 18 months prior. And the students were being offered these huge salaries to do marketing and business development for business with no earnings.

Where was all the money coming from? From firms that had either gone public or were hoping to go public. Because of the dot-com bubble, businesses with not-very-good prospects were selling shares and getting huge cash infusions. And using the cash to buy first-year MBAs out of returning to school.

Do I fault the students who didn't return for school? Of course not --- they're just responding to the price signals that the labor market is sending them. Ordinarily, if a worker is offered a huge salary to do some work, it's because the work to be done is valuable. But here, labor-market price signals were wrong because the financial-market price signals were wrong. The financial market was rewarding entrepreneurs with not-very-good business models, and so the entrepreneurs were rewarding employees to do not-very-valuable work.

So, to summarize this chain: Financial-market prices affect choices in labor (and other) markets. To get the right people in the right jobs, we need financial-market prices to reflect the actual value that firms will create. This is why bubbles are a bad thing. (And think here about all the bad decisions that have been made because of the housing bubble --- it's the root cause of most of our current troubles...)

So how do we pop a bubble? In order to get a bubble popped, we need to provide incentives for the popper to pop it. That is, we need to have a way for someone to profit by making stock prices go down. That's what short-selling does, and that's why it's a good thing.