In the wake of the S.E.C.’s temporary ban on short selling of financial stocks I think it is important to remember that they play a critical role on Wall Street. Most of us want stocks to go up. They bet that they will go down. They play an important role as contrarians, questioners of conventional wisdom.
Two of America’s most spectacular bankruptcies were identified by shorts long before the rest of Wall Street had figured it out. Remember Enron?
The all-time most famous incident of gruff-talking CEOs is of course Jeffrey Skilling berating hedge fund manager Richard Grubman back in 2001 with a word we can’t print in a family-friendly investment blog. Grubman had challenged Skilling over Enron’s failure to produce cash flow and balance sheet data in a timely fashion. Turns out Grubman was on to something in them there balance sheets and Skilling’s less-than-professional response was a leading indicator of Enron’s subsequent decline and fall.
Here is a New York Times article from June 4, when Lehman Brothers was trading at $30 per share.
Lehman Battles an Insurgent Investor
For eight months now, Mr. Einhorn, a rabble-rousing hedge fund manager, has pilloried the venerable Lehman Brothers in an effort to drive down the bank’s stock price, which he is betting against…He questioned how the company valued the assets on its books, and whether it was disclosing all the risks it faces…“Lehman has been one of the deniers,†Mr. Einhorn, 39, said.
A lot of people could have saved a lot of money if they had heeded these warnings. Shorts improve liquidity and often provide cold blooded rational thinking when others have been swept up by irrational exuberance.