Will the resumption of short-selling hurt the market?

The SEC ban of short-selling against financial stocks expired last night, so short-selling can resume today, but the question is whether it will be deadly or no big deal. I think it will be the latter since the real problem that led to the ban was not short-selling per se but the fact that it simply got out of hand and everybody was doing it. Effectively it was a mob running wild on Wall Street and ganging up on companies based on wild speculation and rumor. The ban was effectively a time-out, giving people an opportunity to go back to looking at fundamentals and considering what positions were really warranted. So, even if the serious players stake out the same positions before the ban, short-selling will not have the "wild" character it had before the ban. The ban also had a negative effect on the overall market since a lot of short-selling simply moved to non-financial stocks and long-short hedge funds dumped long positions that they could not match with new short-positions. It also shutdown the convertible debenture funding market since shorting is the preferred technique to hedge investment in the debt of risky companies. Enough positive steps to bailout finance companies have occurred over the past couple of weeks that the mob will have plenty of reasons to think twice before staking out short positions based on the thesis that all banks will fail.

There are two other factors in the short equation. First, the overall market may be near a capitulation anyway, so fresh shorting will be less attractive to serious professionals. Second, the Treasury announcement that it may make direct equity investments in banks may give the shorts serious pause, although the smart guys know that fresh equity investment dilutes existing shareholder value, so it could be a wash, but the uncertainty and potential positive value of helping banks get back on their feet could well give the shorts enough pause to make a significant positive difference.

Finally, the market opening in a bullish mood after heavy selling in recent days will be a scary time for all but the most committed and disciplined of short-sellers. OTOH, when a market is in a bearish trend, the professionals do tend to sell or short-sell into any rallies.

The SEC can also reinstate the ban at will if the prior mob-like behavior does take root again.

I personally am still in favor of further restrictions on short-selling to automatically discourage the formation of the kinds of attack mobs we have seen over the past year, but such reforms are unlikely in the near future. In truth, if the market mobs do not reform themselves, angry Democrats next year will do it for them and in a much more painful and draconian manner.

-- Jack Krupansky