What We Can Learn From Short Selling

Published in Investing Strategy on 22 July 2009

If a company or market is being short sold, it's worth taking a closer look.

It is a fundamental economic law that for prices to rise there has to be sufficient demand. And prices fall because of insufficient demand or a large number of sellers. 

Applying this to financial markets means that for anyone wanting to understand how to better time their purchases or sales of shares, would benefit from understanding excessive selling. By this I do not mean the ordinary, everyday selling by holders of shares. I mean company sales and short selling of shares.

Buybacks are drying up

In a recent research report on the valuation and outlook for UK shares, economist Andrew Smithers of Smithers & Co highlighted the importance of companies engaging in share buybacks. The level of buybacks recently peaked at over £20bn in late 2007 for the UK and an astonishing $1,000bn in the US, just as the S&P 500 topped out around the 1,500 level.

Mr Smithers also draws attention to the high, and increasing, levels of corporate debt that exist in both the UK and the US. The problem is that further availability of finance, via lending from either the banks or the corporate bond markets, is constrained. 

Even if the availability of debt was not a problem, the spread over gilts for investment grade bonds rose to unmanageable levels earlier this year. Smithers sees no improvement in either the credit concerns of lenders or the availability of liquidity. Clearly, the conclusion is that companies will stop buying back their shares.

Now, quite unlike debt-ridden individuals, highly indebted companies can take action to 'wipe the slate clean'. And there's no prizes for guessing how they do this -- by selling more of their shares, via rights issues, and therefore increasing the supply. That's a double negative whammy for share prices.

Pressure from short selling

Short selling is undoubtedly an influence on the value of stock markets. The degree of that influence is currently under debate in the wake of the recent ban on short selling of shares in the financial sector. Regardless, you would (or should) be wary about investing in either a share or a market where there is heavy short selling -- at least if you have any interest in short or medium-term price movements.

The reason for this is that short selling is usually undertaken with more conviction than 'long-only investing' and can involve (especially with hedge funds) highly leveraged positions that amplify gains or losses.

Short selling involves an entity (usually but not always a hedge fund) borrowing shares from their current owner (typically a pension fund or other investing institution, for a fee). 

These shares are then sold on the market (for, say, £10 each) and, if all goes well, the hedge fund buys them back at a lower price (say £8 each) and returns them to the owner. The hedge fund then pockets the difference (in this case £2 per share.)

To illustrate how important short selling can be, at one point last year over 50% of iShares FTSE250 ETF (LSE: MIDD) was loaned out by its owners, mainly to short sellers.

Although there are other ways to short the market, for example stock futures, index futures, spread bets, CFDs, total return swaps etc, these need not concern us here: short selling is a pretty good proxy for negative views.

Getting the relevant information

Fortunately for the UK investor, company share buybacks and rights issues are the subject of regulatory announcements and are documented in most investment websites. Monitoring the balance between purchases (buy-backs) and sales (rights issues and similar) is relatively easy.

Similarly, for the US investor, information on what is called 'short interest' (the total number of shares investors have sold that have not been re-purchased is published on a number of websites such as this one.)

However, there is no single authoritative UK source of the amount of short selling in the UK market. This is annoying although, to be fair, the FSA is currently trying to address this problem.

I have found two sources which offer some information for the UK investor; Euroclear and dataexplorers. Euroclear, on its UK site, issues a list every month of all shares out on loan and what percentage of their market capitalisation is loaned out.

For anyone interested in the broader markets, rather than individual shares, dataexplorers is quite interesting. It provides a monthly index on a variety of markets called the DESLI (Data Explorers Stock Lending Index), which tracks the changes in loans to shares outstanding. The higher the index, the more shorting exists.

The data appears to show short interest declining, which may be positive news for the markets. However, I have already mentioned that one of the indicators under discussion; company buy backs, and rights issues, looks negative for shares.

The short-selling indices from dataexplorers looks more positive. All the indices tracked by dataexplorers show them to be well below their 52-week highs, and since May the DESLI GLOBAL 50 has declined from about 160 to nearer 70. The most positive news is from Asia where, according to dataexplorers, the DESLI Asia (ex Japan) hit "...a 52 week low of 53.15 on March 31. The index has almost halved since January 2008.

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The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

DiscoFinance 22 Jul 2009 , 5:21am

There is a great movie about short selling and market manipulation called: Stock Shock. You must see this movie--nothing else explains it like Stock Shock. People in the US are sending their copies to the SEC. stockshockmovie.com

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