Short Selling Spuriousness

By Stephen Pope of Spotlight Ideas

Blame policy makers not the market – If assets are sold it is because they are mispriced – Volatility will actually increase.

On Monday, July 23rd 2012 2 Euro Zone nations acted in a manner that revealed panic and questionable judgement. In an attempt to prevent “speculative” trades depressing asset values Italy and Spain reintroduced a ban on short selling. This was a response to the tumble in the equity and bond markets.

Before one sagely nods one’s head and thinks it is a good idea, we at Spotlight urge the reader to ask a simple question:  Why are the markets selling Italian and Spanish assets so aggressively?

The data presented in Figure 1 shows exactly how bad the finances of Italy and Spain are.

Figure 1: Gross Debt Levels : GDP (%) Italy & Spain; Germany is a reference. Source: World Bank

An investor will only place money into an asset if there is an expectation that the value of said asset will improve. If the opposite view is held, i.e. the assets value will decline that removing the asset from a portfolio to hold either cash, or an alternative instrument is the correct policy.

Running a short position is a perfectly natural feature of the market as there are on a daily basis many millions of Dollars, Euro’s, Pounds or yen that are put to work by exploiting a shift in the shape of the yield curve.

Table 1: Curve Play In US Treasuries Source: United States Treasury, Bloomberg

In Table 1 we take data of weekly closes in the US Treasury market, the most liquid asset market in the world. In week 22, June 1st the 2 year Treasury, “T2” closed at 0.25% and the T5 at 0.62%. The spread in the yield curve from the 2 year to the 5 year was +37bps, 62bps – 25bps or 37bps. Over the week the T2 yields edged higher by 2bps and that of the T5 by 9bps. A spread
trade could have been built on the basis of:

Table 2: US Treasury Spread Trade Mechanics Source: Spotlight Ideas







Here the theoretical investor has made a play on the curve and by be able to go short has booked a gain over the week of 7bps.

The United States of America faces many economic and financial difficulties and yet the market is allowed to operate in a fairly free manner. The true value of an asset is what the market says it is. Sometimes the market applauds and will go long, on other occasions it rejects the nonsense that is uttered by politicians and bureaucrats. That is why yields rise and prices fall, i.e. there is no confidence in the policies being implemented or in those that are implementing them.
A natural response from those on the hard end of the markets judgement is that the market is wicked and is occupied by “locusts” that reap havoc and devastation.


• The market is the purest evaluation of true value.
• Asset prices fall because the policies being applied are wrong.
• Assets prices collapse because denial and deception simply beggars belief.

The ambition that is behind the short selling restriction is to dampen down the volatility that has been seen in recent trading sessions and yet the evidence on the trade this Tuesday morning is far from compelling. The bonds are heavily lower as is the FTSE MIB and the IBEX in particular. Clearly investors are throwing out assets that are seen as rapidly becoming junk.

The rejection of Spanish assets was seen with a particular sharp focus as the auctions for 3 month and 6 month bills could only be placed as much higher yields than was required last time these maturities were auctioned.
• 3-Month at 2.434% from 2.362%
• 6-month at 3.691% from 3.237%

Taking the data on equities and bills/bonds it makes the Monday comments of Spain’s stock market regulator, CNMV appear ludicrous and naive.
“…Given extreme volatility in European stock markets that could disturb the orderly functioning of financial activity it is  necessary to review stock markets’ operations in order to ensure financial stability…”

CMV was not even original in its thinking as it said the decision to ban short selling had followed the ban by Italy, where the market regulator CONSOB said the ban was being reinstated because of the current situation affecting financial markets.

French regulator AMF, which has banned short selling in the past, said it had no plans to follow suit. For now…we are convinced the markets will against France in due course…just wait and see what President Hollande and AMF say then.

Panic In Play:

We at Spotlight believe the market should use this stance by Italy and Spain as a reason to completely reject all assets from these nations as we believe the market should en-masse call into question the decision to ban short selling. It is clearly an act of panic and reflects the widespread nature of the “Infection Vectors” that have swept through the single currency region where dogmatic prejudices have nurtured an inability to grasp the reality nettle and enact Euro Zone wide measures that are required to rebuild confidence.

Throughout the Euro Zone crisis we have seen repeated examples of :
• Rising market volatility because decision taken at summits possesses no clarity on the
reality behind the measures.
• Applying a short sale ban creates even greater volatility…because eventually shorts have
to be covered. Shorts create a natural “spring” dynamic in the market.
• Assets prices, debt and equity have deviated from their fundamental value.
• Imposing a short selling ban heightens fear and magnifies risk/return scenarios.
Q: “What are you not telling us? What is the government hiding?”
• A short selling ban actually enhances the “skew” or “kurtosis” in market.
A fundamental task in many statistical analyses is to characterize the location and variability of a data set. A further characterization that can be drawn from the data includes the degree of Skew(ness) is a measure of symmetry, or more precisely, the lack of symmetry.

Kurtosis is a measure of whether the data are peaked or flat relative to a normal distribution, i.e. data sets with high kurtosis tend to have heavy tails. This definition of kurtosis should be interpreted asindicating that the standard normal distribution has a kurtosis of zero.

According to recently published data by the ECB and BIS the majority of market participants that seek to set a short position are market makers that are hedging their bets on the options markets or playing the shape of the curve. Options can be lagged and constructed so as to allow synthetic short positions continued to do so.

Other institutions involved in short selling are largely hedge funds. However, average return over the last 5 years for hedge funds using short sale positions coupled with mean reversion arbitrage and long/short strategies was 3%, 4.75% and 7%, respectively. This is not anywhere near what one might say was a super normal return.

In brief, short sellers are not the guilty party, in fact shares that have been the object of the short selling ban end up being relatively unaffected by it. Why? Because what is sold short has to be bought back, eventually.

In 2011 when France, Belgium, Italy and Spain implemented the short sale ban on August 12th, trading volume in financial names in those markets decreased dramatically. Volume in financials in markets without the bans continued to be elevated. During the 2001 short sale ban, financial names in the countries with the ban performed similarly to financials in countries with no ban.

Figure 2: The 2011 Short Sale Ban On banks Had Little Impact Source: Market Media

All we can really say is that the action from Italy and Italy is driven by yet more reluctance to accept responsibility for the domestic economic malaise. Instead of applying hard hitting policies that actually attack the problems of the individual nations. Measures have either applied with too much vigour or have been watered down so as to be ineffective.

In Italy the political pot is bubbling and as to who will lead the nation after April 2013, the market has not a clue. As for Spain, there is resentment in the provinces. The PM refuses to defend his programme in parliament and no one either in Spain or abroad will accept the fact that Spain is bust and needs assistance in an official capacity …not ever more evasion and denial.

Blaming the market is the highest of all follies. If investors cannot “trade” nations bonds, they will go and find another instrument to trade be they long, short or simply flat.

Stephen Pope is  Managing Partner of  Spotlight Ideas. He can be contacted at