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Current time:0:00Total duration:13:55

Video transcript

I think we know enough about shorting now that we can start thinking about whether it's a good or bad thing to have in financial markets. And what I've done here is I've drawn a hypothetical stock chart for a company. This time right here. This is the price of the company. And let's just say that this is a chart in a universe that doesn't have short sellers in it. So this is all-- here a lot of people are buying the stock, then over here some people, maybe they get freaked out or whatever, they start selling. And then more people buy. So demands a little higher than supply, so the price goes up. And that just generally drives the volatility. Now in a short selling world, what would happen? Let's let's think about two scenarios, a short seller who makes money, and a short seller who loses money. So a short seller making money. What would a short seller making money have to do if this is the stock chart. Obviously, they don't see the stock chart beyond the day that they're actually making the trade, but in order to make money they'll actually-- they'll have to short at the local peaks. And they would have to cover their shorts at the local minimum. So a good short seller-- or you can even say a perfect short seller would maybe short here-- let me make it a different color so you can see where he's acting-- would short here and then cover there. And he would make that much money on that move. And then he would wait a little bit, wait for the stock to get expensive again in his mind. And he would short here, and then he would cover here. This would kind of be-- obviously it's very unlikely that someone could so well pick tops and bottoms. But let's say they're just really good at their analysis and figuring out market psychology and things like that. And they would just keep doing it. They would short here and cover here. What would that actually do to the stock? The green line was a reality where you had no short sellers. Now if all of a sudden you allowed short selling, and they had these guys come into the market who know how to make money shorting. He's shorting up here. So what would shorting do? Shorting is you're borrowing the stock and selling it. So he's creating extra supply for the stock, right? So what he would be doing at this point, by shorting, is he would actually be lowering the price at this point. So let me draw the curve. So if there's a bunch of short sellers acting in this range, it would actually lower the peak. Because you have a bunch-- you have some more aggregate sellers. So the price wouldn't go as high. And then on the other hand, these short sellers have to cover right here, right? They're going to cover their position. So at the low point you have more aggregate buyers covering a short position, is just you're buying the stock to pay it back, because you borrowed it earlier. So here you would have more aggregate buyers. And then at this point, once again you have more aggregate sellers, so the price won't go as high. You have more aggregate buyers here, because the short sellers need to cover, so the price won't go as low. And so forth and so on. And the bottom line is, a short seller who's making money on the stock market, so they're shorting the stock at peaks and covering the stock at troughs, is actually reducing the volatility of the stock. And that's good for everybody. That's good for the company's management. That's good for the actual shareholders of the company. And obviously it's good for the short sellers because they are actually making money. And this is actually true for anyone making money in the stock market. That they're reducing volatility. What is a long-- just a regular investor-- or I guess you could call them a trader since they're buying and selling-- a regular trader would make money by buying here and selling here. So really a regular trader is not any different. A regular long trader is no different than a short seller, it's just the order in which they're buying or selling. But anyone making money is buying at low points and selling at high points. And anyone doing that is helping to reduce the volatility in the stock. And even if you're a long term buy and hold player, you would rather sit and hold a stock-- you would rather be a holder of a stock that does this, than a holder of a stock that does this. Now there are a lot of players both on-- you could call them traders because they're buying and selling on a regular basis-- that aren't kind of doing this. Maybe they're piling on the shorts at a low point and they're causing the stock to go down even more. And then, when the stock starts to move up they get scared and they buy it, and it causes the stock to move up even more. And it increases the volatility of the stock. But these guys are being penalized because they're losing money. The people who sell at low points and then buy at high points, and increase the volatility, they're getting killed. They're falling every day. So it's not like you have to create some penalty for those guys. Their penalty is that they're just bad traders, they're bad investors. And they're just going to lose their shirts. So if you're assuming that none of these traders in any way manipulating the markets or spreading false rumors. Anyone making money on a stock, as long as they're not manipulating it, on either the short or the long side, is actually a net asset for the stock. That they're actually reducing the volatility of the stock price. I guess another thing to think about and this is just from a-- it's good. They're reducing the volatility, so from that point sorting doesn't seem too bad, for me, or in general to the market. But another way to think about it is, kind of where are all the incentives in the markets? Who has an incentive to be positive on a stock? And who has an incentive to be a negative on a stock? Or to scrutinize a stocks? Well, the biggest, I guess cheerleaders, for a stock, and it depends on their degree of kind of credibility or ethics, would be the company's management, right? These are people-- it would be company's management. These are people who obviously run the company, but they have the best transparency into the financials of a company, and they tend to be shareholders of the company or get compensated based on how the stock does. So these guys have every incentive to be positive. And, as we've seen multiple examples of, whether you're talking about the investment banks, or Enron, or Accenture, they'll often kind of hide the truth when things get bad. So these guys are definitely big time positive on stocks. Then, let's see, who are the other players or the influencers on financial markets? Well, a big one is the financial press. And I'll write it out here so we can have a discussion about whether they are pumpers of stock or whether they tend to be more-- whether they tend to scrutinize things a little bit more. An important thing to think about with the financial press, and next time you watch CNBC-- and I don't want to just pick on them-- is how do they make money? Do they make money by finding things that are wrong with companies? Do they make money by making you money? No, they make money by selling ads. And then the next question, obviously, is who are they selling ads to? Are they selling ads for mops? Are they selling ads for bicycles? No, they're selling ads to financial services companies. So people who want to manage your wealth, stock brokers, mutual fund companies, anyone who can advertise. And this is key, too, because-- I don't know, you're probably not aware of it but hedge funds can't advertise, so they're not consumers of the financial-- or they're not customers of the financial press. The only people who are customers of the financial press are money managers, financial planners, and things like that-- brokers, mutual funds. And all of these guys benefit when stock markets go up. Obviously mutual fund managers will-- they tend to be long only, so they only want things to go up. Stock brokers-- you might say, oh you know, a stock broker can advise you to go long or short and they just care about how many transactions you make. But in general, more and more people put money into the stock market in rising markets. In a market like you're seeing right now over the last year, people are pulling out-- you could say oh, maybe people aren't doing more transactions, but the general net effect is, people are pulling money out of the markets. So when they're pulling money out of the markets, brokers are getting less transactions, they're managing less money. And that's also true of the money managers. And there's also just another ancillary side effect, is when markets go down and people become less excited about the stock market, people stop watching CNBC and CNNfn. And so even those few ads that are for mops and for bicycles and for cars will get fewer viewers. So in general the financial press, at least in my opinion, is squarely in this camp. And then we can talk more, you know, sell side analysts. You've probably heard the term sell side and buy side. But sell side analysts are the analysts that work for the major brokerages and investment banks, who publish those reports that you see in those ratings, a buy rating on IBM, or whatever. And the reason why they call them sell side analysts is because they work for the people who are essentially, on some level, selling-- you could either view them as they often offer securities, or they offer financial services to, often the companies themselves, or to potential acquirers of the companies. Or they're selling their services-- I mean, usually-- they're brokerage services, so they're trying to get people to transact, they're actually brokers on some level. But clearly these guys, their incentive, since their customer tends to be the management of companies, is to be very, very, very positive. And you should say oh, there are other people who, their whole job is to scrutinize these people. Like, the government. But if you think about it once again, the government likes a rising stock market. It takes-- when people's 401k's are rising, the economy does better, the government doesn't have to worry as much about other types of social benefits, and unemployment, and things like that. So in general, and if you want to be more, I guess, if you want to be more critical of the government, you could also say that they are, to some degree, very close to the management of these firms and to financial companies. And to some degree, these guys have significant clout in terms of lobbyists-- and, well actually, I would even say the bankers, too. They have significant clout in terms of lobbying, and just access to government, generally. And government drives the regulators, so these guys are also on the positive camp. And then finally you have the ratings agencies. And the ratings agencies mainly operate in the debt world. And we'll talk more about that. But, if you can scrutinize a company on the debt level, and you say oh wow, this company really isn't that good, they're not going to be able pay off its debt. That kills the stock. But once again you have to realize that the rating agencies are also paid by the bankers, so the rating agencies are also-- have the incentive to kind of not see things when things are bad. So out of everyone in the financial services, or the financial world, that we've talked about right now, they all benefit when stocks continue to go up. Even when they go up beyond what they really should go up. And even if they all kind of know that things are a little bit too expensive. Or this management team might be a little shady, or they might be covering up something. None of these people really have an incentive to expose it. And the only people who do are the short sellers. These are the only people who really have, arguably the sophistication and the time and the monetary incentive to really look and scrutinize what management is doing. To really look in the books and kind of put a puzzle together, or put a bunch of pieces together to come to the conclusion, wait, the numbers that management is spouting really don't add up. And because of x, y and z, this company really is overvalued. So to a large degree they are kind of on society's side in preventing management from kind of being overly bullish. And I don't want to sound like someone who just broadly is defending short sellers. There is a class of short sellers that I think would be bad, and that's the people who are spreading false rumors, and being market manipulators. So there's just the general market manipulation, or rumor mongering. And that definitely is bad, and to some degree, if you can show someone is doing that, there should be some type of penalty for doing it. But even there, and just it in my experience participating in public markets, if I had to pick-- if I had to pick between the left side of that chart, between this side of this charge and this side of this chart-- and if I had to say who does spread false information when it does get spread? I think often times management is a little bit more guilty of it than the short sellers. In fact there's very few times that I've seen where the short sellers are-- there's some negative thesis on the stock and where it really comes out to be completely untrue. Although, there are examples, and those short sellers, I don't think are really in the mainstream Anyway, I don't want to meander too much. I realize that this video has already gotten long. But I thought it's a nice, useful discussion to maybe think a little bit about whether short selling really is all that bad, even if you are a long investor.