Short sellers claim there is a moral and economic worth to their trade. They supposedly keep the market honest by exposing overvalued stocks, thereby preventing “irrational exhuberance” from creating stock bubbles.
If that was all there was to it, they’d be right. Stock bubbles tend to eventually pop, and when they do, worst case, the collateral they represent implodes, the loans that the collateral enabled go into default, and trillions in debt fueled liquidity is erased in a cascading downward spiral. And just like that, the economy collapses into a deflationary depression that makes the 1930s look like a cake walk. There are good reasons we don’t want to demonize short sellers indiscriminately, or drive them out of the market.
What’s happening with Robinhood and the Reddit mob, however, exposes the gritty reality behind the high-minded justifications for short-selling. Yes, short-sellers play a vital role in regulating stock market levels. But the world of short-selling is an elite club, rife with intrigue and shady players and deliberate market manipulation. And when an online mob crashed the party and pissed in the punchbowl, suddenly the bouncers came to life.
This is the point to emphasize: Reddit and Robinhood didn’t do anything that elite Wall Street hedge funds haven’t been doing for years. They just did it publicly, using an online mob of small players, and were indifferent to the impact it would have on elite institutions that have become accustomed to raking billions in profits out of the market. When interlopers play by the rules, they’re still interlopers. Time to change the rules.
Here’s what happened. A short sale refers to a contract whereby an investor borrows shares of a stock from a broker and sells those shares at their current price. The investor now has the money from that sale, but within an agreed period of time they have to pay the broker back with shares, not money. This works out well for the investor if, as a short-seller anticipates, the stock price goes down. When the price falls, the investor uses a portion of the money they made (by selling the stock they’d borrowed from the broker) to repurchase those shares at the lower market price, then they keep what money remains as profit.
The risk the investor takes is that the stock will not drop in price, but go up in price. When all goes according to plan, if an investor borrows 100 shares from a broker and sells them for $100 each, they now have $10,000 and they owe 100 shares to the broker. If the price drops to $50 per share, they buy back the 100 shares for $5,000 and keep $5,000 in profit.
That’s not what happened, to put it mildly.
So-called institutional shorts are disclosed on stock profiles in a vital statistic called “short as percent of float.” The “float” refers to the number of shares in a company that are available for public trading. The “short” in this context refers to the number of shares that have been sold in a short sale, meaning they will have to be repurchased. If the “short as a percent of float” is a high percentage, this indicates the short seller hedge funds have targeted this stock, expecting its price to fall, so they can make millions, or billions, in profits when they repurchase the shares at a lower price.
Oops. Here’s where the Reddit mob and the Robinhood online brokerage come into the act.
In a series of posts over the past few weeks that gathered momentum on Reddit, thousands of small investors on the zero-fee upstart trading platform Robinhood started buying stocks that had been shorted by institutional investors, driving the price up instead of down. Most notable among these stocks was GameStop, which was trading at under $40 per share as recently as January 21, but thanks to an online mob of buyers, peaked at $468 per share just a week later on January 28. Other similarly targeted stocks also shot up in value.
Reaction was swift. Staring at tens of billions in losses, with no end in sight, Robinhood was pressured into halting purchases of some of the most affected stocks. The subreddit channel “r/Wallstreetbets” was briefly taken down. But for some, it was too little, too late. One of the hedge funds, Melvin Capital, closed their short position and incurred losses rumored to be in the billions. Others are hoping to ride out the storm, at risk of having to close their positions at a cost of additional billions, if not tens of billions.
But why is it that trading is halted on a publicly traded stock in order to protect billion dollar hedge funds? Apart from its audacious transparency and brazen simplicity, what did the online mob do wrong? How the regulators react to this new kid in town will speak volumes. Who deserves protection? Wall Street? Or Main Street? Billionaire traders? Or dangerously aggregated bands of bit players with their keyboards and their Robinhood accounts?
Reaction to the reaction was also swift, and telling. In a show of unity that is yet another harbinger of populist realignment coming to America, political opposites Donald Trump Jr. and Alexandria Ocasio Cortez spoke with one voice. Both recognize the hypocrisy. Both consider the system rigged. And they’re both right.
Short Sellers Aren’t Doing Their Job, Anyway
Halting trading and shutting down a financial message board is problematic when it is done to arrest a slide of the entire market. But this was done to induce a downturn in the value of select stocks, specifically to protect select Wall Street firms. Good luck justifying that. But there’s a larger issue.
If short-sellers keep the market honest by preventing overvalued stocks, why are stocks so overvalued? Consider the big tech stocks, since they’ve become so concerned about eliminating competitors in the name of protecting us from hate speech and misinformation:
Amazon shares have a price/sales ratio of 4.8 and a trailing price/earnings ratio of 96.3. Google has a P/S ratio of 7.6 and a P/E of 36.7. Apple has a P/S ratio of 9.1 and a P/E of 43.3. Facebook has a P/S ratio of 9.9 and a P/E of 31.0, and Twitter has a P/S of 11.0 and a P/E of 21.9.
A “normal” price/sales ratio for a stock is between 1 and 2. A “normal” price/earnings ratio for a stock is around 15. If big tech stocks were trading at normal, historically sustainable sales and earnings ratios, they would collectively lose trillions in value. They are not alone. The so-called superbubble in asset prices has never been bigger, and “short-sellers” aren’t doing a thing to effectively counter it. There’s a reason for this.
Short sellers don’t necessarily target overvalued companies. They can’t. The market is not rational enough to permit short sellers to do the job they claim they have a moral mandate to do. Short sellers target companies that they think will go down in value, for whatever reason. Those reasons can be based on deliberately spread rumors as easily as financial metrics.
What’s really happening is investors are terrified of a deflationary spiral, which can only be triggered one thing – a massive crash in the value of collateral. Overvalued stocks, bonds, and real estate are the assets that collateralize what has become the biggest borrowing binge in the history of the world. As long as asset values don’t crash, the party will go on. Keeping asset values rising, no matter what, is the motivation behind policies ranging from the Green New Deal to immigration to foreign entanglements. Examine these policies through that filter. Much will be revealed.
Online innovation and online freedom has just ran into another wall. On this new front, the financial front, expect new regulations, periodic shutdowns, and more censorship. It will be to keep us safe. It will be to protect unsophisticated investors. It will be another part of the new normal.
This is what we can expect from Biden’s financialized economy, ascendant now over Trump’s productivity economy. Biden’s model consolidates wealth at the top, while flirting with a catastrophic economic crash. Trump’s model offered a sustainable way out, rewarding productive enterprise at every scale.
This article originally appeared on the website American Greatness.
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Edward Ring is a contributing editor and senior fellow with the California Policy Center, which he co-founded in 2013 and served as its first president. He is also a senior fellow with the Center for American Greatness, and a regular contributor to the California Globe. His work has appeared in the Los Angeles Times, the Wall Street Journal, the Economist, Forbes, and other media outlets.
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