As European stock markets continue to exhibit weakness, Spain’s stock market regulators today banned the short-selling of stocks for the next three months. Earlier in the day, Italy’s stock market regulators re-instituted a temporary ban on the short selling of financial stocks.
“Selling short” is the process of selling a stock first (by borrowing the stock from a broker) and then buying the stock back at a later date (and returning the stock to the broker) with the expectation of profiting from a decline in the stock’s price. “Going long” is simply the process of buying a stock with the expectation of profiting from a rise in the stock’s price.
This type of short selling ban by governments is nothing new. Government regulators in many different countries have often reacted to adverse stock market conditions with similar directives.
This type of action is usually taken by regulators during times of severe market declines with high volatility. Government regulators think that extreme volatility is a disruption to the orderly functioning of the market, so they often decide to “do something” in order to appease their constituents.
However, it is unrealistic to expect the stock market to only go up, so the prohibition of short-selling during market declines is fundamentally irrational. Conventional investment wisdom assumes that asset classes are long-only investment vehicles, so it has become accepted that being long is “good” while being short is “bad”. This is ridiculous.
During extreme market moves to the upside (such as the rally in the US stock market following the March 2009 low, for example), should governments institute long-buying bans to curb extreme market volatility? Of course not! You will only see governments act to try to prevent stock market declines, not rallies.
As with most government actions, short-selling bans fail to produce the desired outcome, and oftentimes exacerbate the situation that regulators are attempting to “fix”. Short-selling bans often have unintended consequences. As I discuss in Myth #10 of Jackass Investing, short sellers provide the stock market with liquidity when they step in to sell short stocks that become over-hyped by emotional buyers. In addition, short sellers must buy back stock in order to close their positions, so by instituting short-selling bans, governments essentially remove a source of liquidity during times when the markets need it the most.
Don’t just take my word for it. Numerous academic studies have also shown the ineffectiveness and potential damage due to short selling bans and have confirmed the positive contribution of short sellers to market efficiency. In fact, contrary to the intent of governments when instituting such bans, studies have shown that banning short selling reduces liquidity and increases volatility.
The belief that short selling destabilizes markets is a myth.
As a result of their ineffectiveness and misguided beliefs, I am awarding a Jackass Investing “Poor-Folio” Award to . . . the Spanish and Italian market regulators responsible for instituting short-selling bans.