Short Sellers and the Role They Play in the Market

Short Sellers and the Role They Play in the Market

When politicians don’t have answers, they blame speculators, financiers (Wall Street), or foreigners.  They do anything to take the spotlight off their culpability or ineptitude.

The above saying is similar to the idea that when a company blames short sellers, it is usually a sign that the short sellers are right, and the company is mismanaged.  Think about it: when a short seller builds a short position, someone else is building a long position.  The borrowed shares that are sold have to be sold to someone.  Also note that the shorting does not change the cash flows of the company. Even the dividends don’t change because the shorts pay dividends to the extra shares.

The shorting is a side bet on a greater question: will the company be able to produce free cash flow adequate to justify the current stock price?

What applies to companies also applies to nations.  During a debt crisis or a currency crisis, there will be an appeal against speculators that are shorting the debt.  Well, guess what, for every unit of debt shorted, there is another party buying the debt.  This applies to credit default swaps as well – on the other side of the trade there is a guy saying, “What a nice yield.”

The politicians complain, but they could fight back: they could buy in their debts and squeeze the shorts.  What’s that, you say?  If they did that, they would either have to raise taxes or cut programs?  And that is anathema?  Well, then the shorts aren’t to blame.  The government is to blame; it has made its own bed, let them sleep in it.

After all, shorts target companies that are mismanaged; they have no free cash flow, and can’t fight back.  The same for nations that are mismanaged; they have structural budget deficits, and a political culture that won’t change it.  No surprise that the shorts show up.

The shorts don’t change anything; they recognize a fundamentally weak situation, and locate a stock lender and a dumb buyer.  Same thing for a bond lender, and a dumb buyer as far as countries or deeply distressed companies are concerned.  And all of this can occur via derivatives if this is the best manner of doing the trade.

In the end, only free cash flows matter, and companies with large free cash flow never have to worry about the shorts.  Same for nations that have their budgets in accrual balance.

By David Merkel, CFA of alephblog