Disappearing shorts: As stocks soar, skeptics surrender

NEW YORK » The skeptics on Wall Street have gone missing s the stock market has surged to records — unbowed by recession, pandemic or warnings of a dangerous bubble — activity has dwindled to a nearly two-decade low for the traders known as short sellers, who make their money betting stocks will fall.

This saddens nearly no one. From small-fry investors to members of Congress, critics paint short sellers as merchants of pain. People around the world celebrated early this year when Gamestop’s stock suddenly hurtled higher, causing billions of dollars in losses for short sellers. Many called it a long-due comeuppance.

But academics and short sellers themselves say they provide an important service suited for just this moment: pushing back against stock prices that may be rising too high, too fast. Despite concerns about the pace of the economic recovery and high inflation, the S&P 500 has set 65 all-time highs so far this year, with the latest coming on Monday.

Some critics say stocks look overly expensive, with some broad measures of value close to historical highs. Fewer short sellers in the market means there’s less selling pressure tugging downward on those prices. It can also mean fewer investors looking for overvalued stocks or ferreting out fraud.

“This is the thing that short sellers do, they lean against the wind,” said Charles Jones, a finance professor at Columbia University’s business school, who has researched short selling. “If you have short sellers who are not afraid to do that, you will not get prices that are too high or too low, which is what I think we want when we are allocating capital.”

Jones’ research of Wall Street in the late 1920s and early 1930s, for example, looked at a group of stocks that were particularly expensive to short, which discouraged short sellers from targeting them. They went on to have returns that were 1% to 2% lower per month than other stocks of similar size, suggesting that they had been overvalued.

When investors short a stock, they borrow the shares from someone else and sell them. Later, if the stock falls as the short seller expects, they can buy the shares, return them to the lender and pocket the difference in price.

So it’s no surprise that short sellers regularly get blamed for driving stock prices artificially low. During the 2008 financial crisis, a few days after the collapse of Lehman Brothers, U.S. regulators temporarily banned the shorting of financial stocks, fearing short sellers would undermine already weak trust in them and trigger a run on the system.

Nearly four years later, though, a study by a New York Fed economist and professors at Notre Dame suggested the ban did little to slow the decline in bank stocks, which fell anyway. The restrictions also gummed up trading for bank stocks, raising trading costs in the stock and options markets by more than an estimated $1 billion.

Shorting activity has been trending down since July 2008, a few months before that temporary ban. Then, it was nearly twice the force it is now, accounting for 2.61% of all the shares in S&P 500 companies.