Hindenburg Omen & Short Selling Hooey

Lately there has been a lot of talk that we may be metaphorically standing in Lakehurst, New Jersey in 1937, waiting for the stock market Hindenburg to burst into flames. The lead story in the New York Times on Sunday described how small investors were fleeing the market (which I always thought was a contrary indicator but... whatever).

Well folks, I have a stock market crash prediction. I predict that if the stock market crashes, short sellers will be blamed -- and it will be hooey.

True, this isn't much of a prediction. Shorts are always blamed for crashes and it's always hooey. But I can be especially confident because of a recent report by the staff of the International Monetary Fund. It shot to pieces the most recent short-selling hysteria, which took place in Europe. As I explained in this space back in May, Germany was barking up the wrong tannenbaum when it imposed a lavishly publicized ban on certain types of naked short selling. It was a cynical and blatantly political act, with the Wall Street Journal reporting that it came "amid rising political pressure in Germany to tackle speculation that politicians blame for exploiting and worsening the euro-zone debt crisis."

My feeling in May was that this was a publicity stunt, part of a long history of using short-selling, particularly "naked" shorting, as a scapegoat for fraudulent companies. In fact, it understated the "hooey" case. The IMF report made a series of findings that were utterly unsurprising to anybody who even half-consciously follows this issue. Among other things, the IMF found that

1. Nein! Shorting didn't hurt the market: "Evidence suggests that most of the adverse market movement in the current crisis can be attributed to fundamental factors and to uncertainty due to partial or inadequate disclosures. In effect, downward price movements are due to many factors other than short selling. In efficient markets, negative information should have a negative price impact. Short selling restrictions impede the flow of negative information into prices."

2. Past naked short-selling bans "did relatively little to support the targeted institutions' underlying stock prices, while liquidity dropped and volatility rose substantially." The IMF concluded that a permanent ban on naked shorting is not a good idea.

What's interesting -- no, a better word would be "annoying' -- about the IMF paper is that it is not even the slightest bit surprising. As the paper points out, in a footnote on page 11, a series of studies have emerged since the 2008 financial crisis finding that restrictions on naked short-selling, including the dreaded (and largely mythological) "naked" variety, did not prevent bank stock prices from falling, and can have "outright negative effects on market liquidity, quality and efficiency."

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