Will the European Ban on Shorts Be a Savior or Crisis Catalyst?

Last Thursday night the European Securities and Markets Authority placed a ban on the short selling of shares in France, Belgium, Italy and Spain. Though this would constitute a major mistake in any market, given today’s market uncertainty, a ban on essential market sleuths is the potential path to a market crisis.

To understand why, it has to be remembered that to attract investors, markets must be realistically priced. Short-sellers, for infusing share prices with potentially negative information, help bring reality to the marketplace.

Of course today’s markets are by no means normal. As evidenced by their violent fluctuations over the last two weeks, stock markets in Europe and everywhere else have a crisis quality to them, thus making the existence of short sellers ever more necessary. Indeed, if they didn’t exist, we’d have to invent short sellers precisely for times like the present.

That’s the case because by virtue of the harsh market selloffs of recent vintage, the stock markets need buyers. The problem is that buyers will materialize in less impressive numbers if negativity is not allowed to inform the prices of shares. Simply put, no investor wants to overpay for stocks, particularly right now when another correction could wipe out one’s investment.

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Secondly, short selling is often part of a long buying strategy. No doubt there are shares of healthy French and Italian companies that investors find attractive right now, but as a way of protecting their downside, some investors surely want to short the shares of correlated, seemingly less healthy companies as a way of covering their losses assuming their long position proves incorrect.

The above scenario is a bullish one, and is of notable importance to struggling economies like those in Europe at the moment. A short/long strategy ensures that failed ideas are quickly starved of capital, while the well-run entities, for their share prices rising, receive more capital necessary for expansion. But with short sellers banned, capital stays locked up in the failures at the expense of successes.

Thirdly, and perhaps most importantly, it must always be stressed that short sellers are ultimately buyers. To sell shares short, an investor must go into the marketplace to borrow shares from an existing shareholder, then sell them.

Profits result from this most risky of investment strategies (since there’s no limit to how much the share price of anything can rise, potential short sale losses are unlimited) if and only if the share price of the company sold short declines. If so, the investor uses the proceeds gained from the initial short sale, and re-enters the market to buy the shares sold short that are now selling at a lower price. The short seller must re-enter the market because the shares borrowed from the initial shareholder must be returned.

When we think about the above, it quickly becomes apparent how very necessary – indeed, vital – short sellers are to unhealthy, downward moving markets. Though short sellers are incorrectly demonized for rendering negative opinions on share prices, the only way they can profit for being correct is to re-enter the marketplace to buy what they borrowed and sold.

In short, the allowance of shorts into the market is the market’s way of building up a major reserve of buying power. So while short sellers correctly profit when share prices decline (they should for bringing truth to prices), and are criticized for doing so, not mentioned enough is that short sellers are the buyers when markets most need them. Remember, to profit they must re-enter the stock market to buy what they borrowed and sold.

Going back to 2008, though the collapse of Lehman Brothers could never have caused a financial crisis, it’s fair to suggest that the SEC’s ban of short selling on 900 different financial stocks in fact did. The reasons are basic.

As mentioned above, in 2008 we were in the midst of a financial crisis, and because of that, investors were most fearful of financial stocks. In that case, efforts to ban short sellers of financial shares effectively banned information; and without information potential buyers were necessarily reluctant to commit capital. Why overpay for shares that look dicey even without the existence of short sellers?

Secondly, no doubt many investors wanted to buy an apparently healthy J.P. Morgan (NYSE:JPM), but only if they could short another seemingly correlated company to protect their downside. But with short-sellers banned, the market was hampered in its ability to prop up the healthy while putting the sick out of their misery.

Lastly, we all remember from back then the sickening stock market dives. How nice it would have been then to have short sellers who, after profiting from those dives (and aiding the economy in the process), would have re-entered the stock market to put a floor under falling prices.

The idea that Lehman’s bankruptcy caused the financial crisis once again never made sense, but in a marketplace utterly reliant on information, the ban on short sellers back in 2008 is a far more compelling cause. After that, look to bailouts and the certain damper they put on recovery, not to mention a rush by governments away from market-friendly policies as the two other causes of the much misunderstood financial crisis of 2008.

Back to Europe, as evidenced by the continent’s economic, fiscal and market troubles right now, information meant to bring pricing reality to all three is more necessary than ever. When markets lack information, panic is frequently the result, so assuming last Thursday’s ban of information has teeth, those with European exposure might want to look out below. Much worse than the near-term pain brought by short sellers is a market that lacks them altogether.

John Tamny is editor of RealClearMarkets and Forbes Opinions, a senior economic adviser to H.C. Wainwright Economics, and a senior economic adviser to Toreador Research and Trading.

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