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January 29, 2021 Reading Time: 4 minutes

Back around 2007, investor John Paulsen began to feel skeptical about the viability of mortgage securities. Though demand for them was much greater than supply, Paulsen sensed that lending standards had plummeted so far that loan delinquencies were set to surge. The “third rate” hedge fund manager (that’s what those who covered him at top investment banks felt) proceeded to very inexpensively purchase insurance on mortgages. He was able to because the consensus in the marketplace was that he was very wrong.

As readers know, Paulsen was subsequently vindicated in 2008. Funny about the billions he made on his bet was that all-too-many looked askance at his remarkable gains. Paulsen was said to be profiting from the pain experienced by borrowers and lenders. In truth, Paulsen was a hero.

His major investment gains sent a crucial signal that lenders should shrink their exposure to home loans. Realistically billions were diverted from a form of lending that, at the time, was no longer viable. Translated, Paulsen’s billions helped avert what would have been a much bigger economic crash if the faulty lending had continued.

Paulsen’s story is a useful way to approach all the overdone excitement about GameStop. Without presuming to know the intimate details of the gaming retailer, all the talk that its soaring share price is happy evidence of the small investor striking back against big bad hedge funds who were short the company’s shares is patently absurd.

For one, it’s not very reasonable to suggest, as some do, that a collection of investors inspired by Reddit could routinely move markets; thus putting those allegedly awful hedge funds out of business. For those who think otherwise, they might attempt to make it their investing strategy to join the Reddit herd in the future.

That’s the case because the stock market is a lot more complicated than simple supply/demand, and huge demand surges resulting in soaring shares. The reason for this is that a company’s valuation as expressed through shares isn’t solely a consequence of share scarcity as much as it’s a speculation in the marketplace about all the dollars said company will earn over its lifetime. In other words, every public company would aggressively limit outstanding share count if it were the path to a tripling of its value. It’s not.

Back to GameStop, the alleged revenge that small investors are enjoying over hedge funds is rooted in a misunderstanding about short sellers. In this case, it’s said that a few hedge funds were short GameStop’s shares, the shares have surged as everyone knows, which means a few hedge funds are said to be collapsed.

The populists are cheering! Those awful traders will learn to never short again! Let’s wipe out a few more of these producers of misery!

Actually, if it’s true that a few hedge funds were wiped out by GameStop’s surge, it’s a reminder of how heroic hedge funds are in the first place. It’s a reminder that if they didn’t exist, we would have to invent them. Think about it.

There is arguably no riskier market move than to short a public company’s shares. In doing so, a public-company skeptic borrows shares in the marketplace, pays for the right to borrow the shares, then sells them. The investment or bet in being short is that the investor who is short will be able to re-enter the market, purchase the shares previously sold short, only at a much lower price. The profit is in the difference between the proceeds taken in when selling the borrowed shares versus the cost of buying back the shares borrowed. It’s a great trade…if it works.

It seemingly didn’t for some institutional investors who were short GameStop. Shares that were trading around $4 six months ago are now commanding somewhere north of $300. It’s a reminder of how incredibly risky it is to be short any public company. While your trade can make you money if you’re correct that the shares are due for a fall, the simple truth is that the downside to your short position is endless. See Gamestop price once again to understand this.

“Serves them right,” some will say. “Short selling is a seedy act whereby big investors attack an innocent company and drive its shares down to nothing. Maybe GameStop will serve as a lesson so that this vindictive form of trading ceases to exist.” Let’s hope not.

To see why, please re-read the last few paragraphs. A short seller borrows shares, sells them, and pockets the proceeds on the assumption that re-purchase of shorted shares will come at a cost that is less than the proceeds gained from the sale. Stop and think about this for second. Maybe a few. Short sellers are by definition buyers. In order for them to take profits on their speculation, they must re-enter the market and buy back the shares they previously sold.

Short sellers don’t drive down markets in vicious fashion as much as their presence as size sellers is a happy sign of growing buying power in size. Again, buying is an essential part of any short sell.

After which it’s time for everyone to get real. Prices are the way that market economies organize themselves. It’s through prices arrived at freely that retailers know which items to stock and which ones to not, plus it’s through share prices that those with precious capital to allocate know where investment is needed, where it isn’t, where it will be wasted (think mortgages back in 2008), and where it will be rewarded. Without honest prices in the marketplace, the economy and stock market would plummet.

Please keep this in mind as pundits make their silly arguments about GameStop’s price action signaling a shift of power away from hedge funds, and back to the little guy. Such a view isn’t true, plus it ignores the heroics of short sellers. They’re in truth price givers, and the economy couldn’t function without them.

Reprinted from RealClearMarkets.

John Tamny

John-Tamny

John Tamny, research fellow of AIER, is editor of RealClearMarkets.

His book on current ideological trends is: They Are Both Wrong (AIER, 2019)

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