Keynes’ words have become one of the most tired clichés in finance. “The market can remain irrational for longer than you can remain solvent.” I can’t find date attached to the quotation, but since Keynes died in 1946, it’s a fair guess that he uttered those words at least 60 years ago. Yet, his words are just as true today as they were then. That, I claim, is a blot and a shame on the profession of finance.
Markets are human institutions, evolved and invented to serve an incredible social purpose. They collectively are tasked with deciding how we make use of all that is precious, so that we productively employ rather than squander our providence. The financial press often treats markets like sporting events, like a kind of casino, or a thermometer for the “economy”, like all kinds of things. But markets are not weather, nor idle wagers. They guide what people do and do not do. They determine what is built and created, and what is left merely imagined. Markets guide us in deciding whether to learn computer skills or carpentry skills, whether to drive or to walk to work, where we will live and whether or not to have children. Markets are mind, we are all neurons. We are also the fingers and toes that do their bidding, individually rebellious but statistically obedient.
It is communly understood that markets are subject to “bubbles”. Bubbles are consequential. When markets are irrational, people who behave irrationally, squander resources, and do foolish things may be handsomely remunerated, while people who act sensibly are punished. During bubbles, mountains are moved to create what should not be created, people devote years of their lives to developing skills for which there will be no good use, opportunities are lost and scarce resources are squandered. Estimating the costs of any particular bubble is impossible, because we can never guess what an economy would have done instead of the unproductive things that it did do. But it’s obvious that the scale of malinvestments have often been vast.
There is a fuzzy line between legitimate enthusiasm and risk-taking and a destructive speculative bubble. Reasonable people can and do disagree. Nevertheless, I think any fair reading of economic history shows that speculative bubbles are frequent phenomena, which are often identified contemporaneously by market participants who find they have no way to profit from their correct, but disputed, judgement. So, these insights fail to be reflected in market prices, permitting bubbles to grow without restraint. This is the essence of Keynes’ quote, and it is a remediable institutional failure that decades of much-hyped financial innovation has simply failed to remedy.
The structure of financial markets is systematically biased towards long positions, which reflect an expectation of price appreciation, and are biased against “shorts” who try to profit from expected depreciation. Why? Because a “long”, someone who expects a company or composite to do well, can pay cash for a position, and not worry about the path by which the securities have purchased arrive at a rational evaluation. A “long” can ignore transient irrationalities in the path by which a security arrives at an expected price, and merely bet (correctly or incorrectly) that the expected price will be attained within a reasonable time-frame. This is the strategy that has made Warren Buffet rich. He scours the market for “50-cent dollars”, buys them, and waits. If a stock “worth” a dollar drops from $0.50 to $0.25, or even to $0.01, Buffet, if he is confident of the security’s intrinsic value, can just hold the stock, until eventually what is worth a dollar sells for a dollar. He can ride out transient market irrationality, and if he is correct in his valuation, he profits.
But what about the “5-dollar dollars” in a market? It is just as useful, from a resource allocation perspective, for investors to be able to profit from pointing out misallocations of capital as it is for them to remedy underallocation. But an anti-Buffet, who is as confident and correct as Buffet in his valuations and tries to short expensive stocks, cannot be blithely indifferent to the path a security takes in finding its correct price. Under existing market institutions, ordinary short investors have to maintain a collateral for stock they have borrowed and sold that varies with the path of the security price. If a stock “worth” 1 dollar is absurdly valued at $5, there is no reason to think it might not transiently reach the absurd value of $10. As David Merkel notes, “twice absurd is still absurd.” But while a buy-and-hold investor on the long side can just hold an absurdly undervalued stock, a buy and hold investor on the short side has to “cover” the increased debt implicit in her short position by putting up hard cash. Any short investor can be put out of business by a sufficiently large spike in the price, however transient, low-volume, or downright absurd.
There are lots of differences in costs and risks between “selling short” and “buying long”. There are even some asymmetries — only applicable to very large, very creditworthy, investors — that work in favor of shorts. But for the vast majority of buy-and-hold value investors, the possibility of being 100% correct on the fundamentals but wiped out by a spike makes shorting simply not worth the risk. It’s value investors who force stocks to reasonable prices. So called “technical” investors and traders don’t care, they’ll follow momentum from one greater fool to the next without batting an eyelash. The only value investors who do have the capacity to sell, investors with an previously-purchased inventory, are an unrepresentative sample of the value investment community (bullish enough earlier on to buy), sticky (buy and hold investors usually hold), and subject to behavioral-finance effects like finding it hard to sell a position that’s earning money. Under these circumstances, there is a systematic bias for prices to generally rise, but to fall suddenly when some news or trend calls attention to the mispricing way so vividly that it juices the traders and gets the portfolio investors nervous about holding.
In other words, with the short-side so under-represented among value investors, it shouldn’t be surprising that bubbles tend to gently grow, then suddenly pop. And so they do. And the costs are enormous.
This is not rocket science or genius. This is obvious stuff. Again, that it hasn’t been fixed, that this institutional bias in favor of one kind of opinion has never been controlled, is a blot and a shame on the financial community.
p.s. For some kinds of investments, the bias against shorting is very strong. It is very hard, for example, to short housing. Maybe new derivative instruments will partially change that, but the risk characteristics of futures and options make them also unpalatable to the value investor, and the arbitrage strategies that usually link derivative securities to fundamental investments won’t work well with housing. Bubbles have lots of apologists, and it is easy to confuse the present institutional forms of markets for “nature”, so the idea that markets as presently consituted are badly broken and should be intentionally reformed to track value with price more precisely comes off to many as utopian science-fiction. My opinion is that when the US housing and liquidity bubbles burst, this kind of talk will seem very moderate.
Update History:
- 31-Mar-2006, 5:08 a.m. EET: Miscellaneous small clean-ups, added sentence about how no means of profiting from identification of bubbles implies that bubbles can grow unrestrained.
- 21-Apr-2006, 10:53 a.m. EET: Some small clean-ups, removed phrase “with very diverse portfolios shorting low-cash-flow instruments” in description of investors who can take advantage of positive asymmetries in shorting, because the sentence was too long and wordy.
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I think Keynes said it during the inter-war years. He was a currency trader on the side (never mind insider info, conflict-of-interest and such modern notions). He shorted GBP at times. Made a bundle eventually but went (almost) broke once or twice in the process. Part of the reason why Keynes was a lot more practical than more academics.
The upwards bias is rooted in human need to see nominal growth. For a safer short you need an instrument that let you bet the real value of sth going down. Otherwise shorts eventually lose unless the target go kaput.
March 30th, 2006 at 1:32 pm PST
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HZ — There’s definitely something to be said for academics who have faced the discipline of the market…
The bias against shorts presented by inflation is material, although I think less offputting than the path-dependence of short-position sustainability. All forms of investment are time-dependent. A buy-and-hold long investor who identifies a stock that doubles in 2 years has earned a living. A buy-and-hold long investor who identifies a stock that doubles in 8 years when ten year bonds are paying 9% has purchased extra risk for no additional return. Inflation means that time is even more critical for a short: A short investor who correctly identifies 20% overvalued stock finds her purchase price only 10% overvalued after 3 years due to inflation, if the stock hasn’t reverted yet to its “value”. Stocks are after-all pass-through securities that automatically increase in nominal value as the nominal value of a company’s revenue stream increases. This indeed makes life much harder for shorts than for longs; shorts pay inflation twice, first in diminished capital gains (or increased loss) due to inflation, then in diminished purchasing power of any eventual gains. But longs and shorts both are willing to risk less-than-stellar or even slightly negative returns based on the uncertainty over when a security will find the investor’s estimate of its correct price. Only shorts have to face the prospect of being forced to liquidate their positions at a very large losses, when they remain confident in the correctness of their positions.
Regardless, I do agree that resolving the inflation bias is important. It’s worth noting that large, creditworthy investors who can put the cash proceeds of a short position to use without penalty can hedge the inflation loss by going long TIPS. But under the (really disadvantageous) terms available to an individual short investor, at least in my experience, this kind of hedging is impractical. (One way or another, the brokers I’ve worked with skim away a significant fraction of the cash flow that should be available from the proceeds of the short-sale. In fact, I often pay net interest on accounts full of cash from short-sale proceeds, as the broker pays me below-market rates on short proceeds, but considers the liability represented by my short positions an expensive margin loan. Perhaps there are short-friendly brokerages out there that diminish these costs. If so, I’d like to know!)
There are lots of institutional biases and extra costs that discourage shorts. An inability to effectively hedge the inflation risk is certainly one of them, as are high implicit brokerage costs and the risk of being forced to cover or liquidate during a transient spike. Our markets do effectively discourage shorts, and thus habitually blow bubbles.
BTW, thanks again for continuing to drop by and comment!
March 30th, 2006 at 6:18 pm PST
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Steve, it is nice to have a quiet corner for a chat!
You could buy puts but that is even more time-event dependent. Or you could short and buy out-of-money calls for insurance, which adds more cost. It is not easy to find out exactly how my brokerages compute margin interest in the case of short positions. With all the things we are talking about that are stacked against shorts, I never bothered to try. I believe even a smart guy like Chanos only eked out < 3% over the long term vs > 10% for S&P.
I think even large players pay a hefty interest to borrow shares. Been wondering why that is the case. Maybe they have a side agreement that the one loaning the shares won’t call back the shares within certain amount of time and so gets paid for that promise.
March 31st, 2006 at 12:56 am PST
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“I think even large players pay a hefty interest to borrow shares. Been wondering why that is the case. Maybe they have a side agreement that the one loaning the shares won’t call back the shares within certain amount of time and so gets paid for that promise.”
You may well be right — I really don’t know. If it’s the case that shorting is expensive for everyone, though, then lots of the theoretical basis of derivatives pricing, which depend upon the availability of low cost shorting to create arbitrage constraints, would be expected to work very poorly in the real world. Futures prices on liquid securities, for example, do hew very close to zero-arbitage prices that presume an arbitrageur can short with no costs beyond covering the cash flow due the party who lent the security. This implies arbitrageurs somewhere can short at this theoretical cost, or else that there’s a tinkerbell effect, where market participants are so convinced of the theory never test the arbitrage bounds. I’d bet the latter, that somebody can and does short cheap, constraining the price.
BTW, I do think, given real markets, shorting usually is a bad strategy (except as a means of “underweighting” in a generally long portfolio). Markets are biased to usually appreciate in real terms, and as you point out, inflation in the currencies that underlie them further augment the upward drift. But, “usually” is not always. Rational or no, we’ve created a financial economies thatt appreciate beyond sustainability and then pop, leading to massive destruction of financial value. (This may not be all bad — Maybe the creation of real capacity during the inflations is larger than the real-economy writedown of malinvestment during the pops. A case can be made for a world where the irrationally exuberant create madly and then go bankrupt in the bust; the world keeps their creations, and they create again to dig themselves out of the hole. Maybe that’s “good”. It’s not a very comfortable story, though, and very ineffecient.) With markets biased to inflate, shorting is like gambling at a table rigged against you 90% of the time. It’s the only arrogant presupposition that you can time the crash that ever makes it worth trying.
April 1st, 2006 at 5:06 am PST
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I think derivitives are different. Options can be naked, there is no need to own underlying securities. Buyers of equities, OTOH, get both cash flow (as you indicated) and VOTING RIGHTS whether they buy from short sellers or plain vanilla sellers. While most investors may not care for the voting rights, they are finite and can’t be created out of thin air. It means that the ones loaning shares must give up those rights. (Maybe for a very short term short away from any proxy dates this is not important, creating opportunities for naked shorts — that is you borrow without the knowledge of the owner but then you have to cover and return the shares by next proxy date. I suspect for retail shorts the brokerages have to finagle sth behind the scenes to get all the accounting right.) I don’t know if this explains things as I don’t work within the securities industry. I did read story about how Buffet charges a significant interest in loaning out his USG shares to shorts a couple of years ago.
April 3rd, 2006 at 2:48 pm PDT
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HZ — No argument. It’s just that derivative pricing depends upon the availability of ordinary short-selling as an arbitrage strategy, in which shorts pay no more than the cosh-flow due the security holder. I agree that derivatives are a whole different ballgame than shorts. It’s just if it’s really true that shorting is expensive for everyone, than derivatives pricing makes no sense.
(Naked shorting is usually illegal, which is makes sense for voting shares, but highlights an inconsistency with respect to other instruments. By what rationale is it illegal to naked-short a debt instrument, but okay to conjure credit-based derivatives whose notional principal far exceeds the size of the primary debt issuance? If there is a problem with “third party bets” creating misalignments of incentives and credit risks that harm the markets for base securities, than the scale of derivative markets should be regulated. If there aren’t such problems, naked shorting of pure cash-flow based instruments, and non-voting securities parallel to stock created by naked shorts, should be permissable. I think there are problems with having the scale of some financial markets be wholly out of sync with the actual real-economy financing they are based on, but I don’t think the question of how derivative markets ought to be regulated is well understood. We may have to see something break before we understand how we might have fixed it.)
April 3rd, 2006 at 3:29 pm PDT
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