Shorts in Herbalife start long tug-of-war

Questions over Herbalife’s business model have resulted in what has been described “the hedge fund equivalent of Stalingrad.”  In the midst of this battle royale between hedge funds that on one side include Pershing Square and Greenlight Capital and Third Point on the other, the New York Times raises the question whether short positions should be publicly reported.  In the interest of limiting volatility stemming from investor “panic,” the times writes that it if the SEC required that short positions be reported “it would help the market to at least know what the positions are when large short bets are announced, which might help limit panicked reactions.”

That question is above the pay grade of this blog, but what the Times itself does not fully disclose is that there is a high degree of information about short selling already in the market.  A number of services track short interest and the cost to borrow stock.  Algorithms and trading decision support tools incorporate those data, making the relative degree of short selling in a stock a factor for insitutional traders.

The Times argues that “celebrity investors” can move stock prices with their words alone and that fact might make it difficult for Main Street investors to discern the “truth” about a company.  The influence certain asset managers have is undeniable, but it their reputations are earned and their opinions are an important part of the information flow in the market.  In the short term, stocks with high levels of short interest might be volatile, but over time, the market sorts out the value.  If the short seller is correct, they win.  Fast-acting traders win.  Mom and pop have a decision to make.  That wouldn’t change with a reporting requirement.

And are there not always two sides to the trade?  For every short-seller who has become a household name, aren’t there many more long managers with collectively more influence?  The Herbalife case has attracted big guns on both sides of the argument — each talking their book — and that’s good for the market.  Some, like Bronte Capital have taken to blogging their counterargument to Pershing Square’s thesis.

Is the default reaction of investors to “panic” in the face of potentially bad news as the Times suggests?  I don’t think so.  Some recent short-driven dramas (Sino-Forest comes to mind) involve very suspect companies, so it should not be surprising that those stocks moved lower quickly.  On the other hand, shorts on MBIA and Lehman took years to pay off.

Short selling is a high risk endeavor and the track record of even the most renowned short sellers is mixed. The question of reporting aside, anything that puts a muzzle on short sellers to me will have a negative effect on the market.  Don’t shoot the canaries in the coal mines.

Further reading:  Oliver Wyman produced a study of effects of short selling curbs on equities markets in the wake of the credit crisis.  It finds that markets that require reporting of short positions “become more expensive and difficult venues for all investors to execute both purchases and sales of securities.”