Stewart vs. Cramer: Short Selling Backlash

[Written for the Borsen-Kurier]
Judging from the cable news cycle, the most important story of the last week in the US was a face-off between Jon Stewart, comedian and host of The Daily Show (you can watch the show here), Comedy Central’s fake news network, and Jim Cramer, a former hedge fund trader and host of CNBC’s Mad Money. How did it happen that arguably the most serious journalist in the US, virtually the only interviewer who is willing to ask truly tough questions, is a comic specializing in, as he puts it, “fart jokes”?
Stewart played a clip from the end of 2006, which showed Cramer being interviewed and revealing some of his secrets of short selling: “You want to spread rumors about the company,” he said, “it’s against the rules, but the SEC won’t find out.” After the clip, Stewart says: “I want the Jim Cramer on CNBC to protect me from that Jim Cramer.” Cramer squirmed and capitulated, trying to make it seem that he’s doing everything he can to prevent the kind of abuses he’s just been shown to be adept at, and promising to do a better job as a financial reporter. “That would be great,” said Stewart, pressing on, “but this is about more than you.” It’s about the network, the show, the whole focus on short-term gain at the expense of the little guy, about gaming the system, about the average investor “capitalizing your adventure”.
He’s right, of course, in that financial markets can function like a poker game. As Warren Buffett put it, if you’ve been playing poker for half an hour and you don’t know who the sucker is, it’s you. Shows like Mad Money are designed to draw in more suckers, who then make amateurish blunders, which the pros exploit.
What should be done?
It doesn’t seem to make much sense to try to ban rumor-mongering. But should we ban or try to restrict short-selling? Has short-selling caused the financial meltdown? Short-selling is the practice of borrowing shares, selling them, then waiting for a lower price, which allows the investor to buy back the shares, and return them to the lender, pocketing the difference. The practice of short-selling is having its 400th anniversary this year, and it remains controversial, because it puts the investor in the position of hoping for a decline, and for the last 400 years, short sellers have been blamed for causing markets to fall.
But such a position is untenable. Though it is true that every short sale begins with selling, and each act of selling exerts downward pressure on a stock, the number of short sellers in a market tends to be small, and short sellers tend to be professional (or at least experienced) traders.
Because markets tend to price in available information, rumors cannot bring prices down for long. If a stock is undervalued by the market, its price will eventually rise, just as overvalued stocks will fall. Short sellers do a valuable service by putting pressure on overvalued stocks. Either the shorts are correct, and the stock falls back to a lower value, or the shorts are wrong, in which case they lose money. There is no more effective discipline for traders than losing money. Blaming short-sellers for falling stock prices is like blaming a vulture for the death of a zebra. A vulture is incapable of killing a zebra, but the vulture obviously benefits from the zebra’s death; the rest of the ecosystem benefits from the vulture stripping the carcass.
Short selling did not cause the US stock market to fall. The stock market fell because it had reached a monumentally overvalued condition. To restrict short selling not only locks the barn after the horse is gone, it discourages traders from taking positions which correct overvalued prices.