THE BEAR AND SHORT SELLING
The operations of “bears” in the great speculative markets and the
practice of “short selling” are riddles which the layman but dimly
comprehends. Buying in the hope of selling at a profit, and if need
be, “holding the baby” for a long time and “nursing” it until the
profit appears, is simple enough; but an Oedipus is required to solve
the enigma of selling what one does not possess, and of buying it at a
profit after the price has cheapened. It is the most complicated of all
ordinary commercial transactions. How the thing can be done at all is
a mystery; how such a man can serve a really useful economic purpose
by this process is unfathomable. The layman who tries to figure it out
thinks there is an Ethiopian somewhere in the wood-pile; the thing is
unreal and fictitious. The only way he can understand it is to turn
bear himself and learn by experience.
Why there should be so many bulls and so few bears can only be
explained on the ground that optimism is the basis of speculation, and
hope the essence of it. Yet the market can only go two ways: it is
quite as likely to go down as up. Since sentiment should have no place
in speculation one would think there should be as many bears as bulls,
more of them, in fact, because the market almost always goes down
faster than it goes up, and because nine out of ten of the unforeseen
things that occur result in lower prices.
Accidents like diplomatic entanglements, rumors of war, earthquakes,
and drought are constantly occurring to upset the plans of bulls and
bring fat profits to bears in a hurry, while matters that bring about
higher markets are generally things long anticipated, in which the
profits that accrue to the bulls come about slowly and laboriously,
and always with the attendant risk that a disturbance in any corner of
the globe may bring on a sudden smash that will undo the upbuilding of
months. In theory, therefore, there should be at least as many bears
as bulls in all active markets, but in practice the large majority are
always bulls, to whose sanguine and credulous natures the bear is a
thing apart--a gloomy and misanthropic person hovering about like a
vulture awaiting the carrion of a misfortune in the hope of a profit.
Naturally the layman cannot understand him, and would like to suppress
him.
Despite the fact that the odds seem to favor the bears, there is an
old and true saying that no Ursa Major ever retired with a fortune.
Wall Street has seen many of them, and with perhaps one exception the
records agree that the chronic pessimists have not succeeded. Fortune
seems to have smiled on them at intervals; in the country’s early days
of construction and development mistakes were made that brought about
disaster, but in the long run such tremendous progress has resulted
in America as to defeat the aspirations of any man or group of men
who stood in its way. The big bears, as a rule, have “over-stayed
the market.” Imbued with the hope that worse things were in store,
they have been swept away by the forces they sought to oppose. One of
them, a power in his day, was so obsessed with the notion that all
prices were inflated, that he has been known to sell stocks short
“for investment.” One night when a lady at his side remarked on the
beauty of the moon, he is said to have replied with that absent-minded
mechanical skepticim inherent in the bear, “yes, but it’s too high; it
must come down.”
One would think the ideal temperament for a speculator would be
absolute impartiality, with an open mind uninfluenced by sentiment,
ever ready to take advantage of all fluctuations as they occur. The
ups and downs of a stock market always show, on average long periods,
a practically equivalent swing each way, so it would seem that the
speculator most likely to profit by these fluctuations would be one
without preconceived prejudices, ready at all times to turn bull or
bear as the occasion required. As a matter of fact, this type is the
rarest of all, being confined, generally speaking, to the professional
“traders” on the large exchanges, necessarily a very small minority
of the speculative group, yet withal perhaps the most uniformly
successful. These men, it must be understood, are not speculators, but
traders, a nice distinction involving “catching a turn,” as opposed to
the speculative habit of “taking a position.”
In active times I have known one of them to operate simultaneously
in the New York Stock market, in the cotton market, and in the wheat
market, trading at the same time in London and Paris, “shifting his
position,” or “switching” from the bull to the bear side twice in a
single day, and closing all his trades at three o’clock with a total
net profit of less than a thousand dollars on a turnover of 30,000
shares, to say nothing of the transactions in cotton and grain. It
goes without saying that to do all these things in one day requires
a curiously mercurial temperament, and calls for nerve and celerity
altogether foreign to the average speculator. Such a man, moreover,
contributes but little to the making of prices and values, which is the
function of large markets; his chief economic usefulness lies rather in
the enormous revenues he pays to the State. The man whose operations I
have just described contributed in a single year $75,000 to the State
Government in stock-transfer taxes.
The scientific way to measure the value of speculators in wide markets
is to consider the bull as one whose purchases in times of falling
prices serve to minimize the decline, and the bear as one who serves a
doubly useful purpose in minimizing the advance by his short sales and
in checking the decline by covering those sales. All these operations
serve useful economic purposes, since the more buyers and sellers there
are, the greater the stability of prices and the nearer the approach of
prices to values.
This, as I have said, is the scientific way to look at it, and the
correct way, but the popular way is something quite different. From
this point of view the man who sells property he does not immediately
possess is thought to be a menace, who depresses prices artificially
and works a disadvantage to the investor or, in the produce markets,
to the producer. Nothing could be more fallacious than this, because
of the fact that just as every routine sale of actual stock requires
a buyer, so every short sale by a bear requires a purchase by him of
equal magnitude. And it is precisely these repurchasing or “covering”
operations of the bears that do the utmost good in the way of checking
declines in times of panic or distress.
When there are no bears, or when their position is so slight as to be
inconsequential, declines are apt to run to extreme lengths and play
havoc with bulls. One often hears among acute and clever speculators
the expression “the bears are the market’s best friends,” and, though
this may seem incongruous, it is quite true. In the month in which
these lines are written there has occurred, for example, a really
severe break in prices on the Stock Exchanges at London, Paris, and
Berlin, arising from the periodic Balkan crisis. This decline ran to
disproportionate extremes, and, in fact, approached such demoralization
that more than 300,000 shares of American securities held abroad
were thrown on the New York market for what they would bring. The
reason for the severity of this decline was easily explained. The
outstanding speculative account at all European centres, while not
actually unwieldy, was almost entirely in the nature of commitments
for the rise. There was no bear account. Therefore all Stock Exchanges
were supersensitive since they lacked the steadying influence which
covering by the bears invariably brings about. The bears are then, in
truth the market’s best friends, and the more there are of them, the
better for all concerned when trouble comes.
Throughout all the political agitation in Germany which culminated
in that disastrous failure, the Bourse Law of 1896, there appears to
have been very little opposition to the bear and the practice of short
selling; nevertheless in that section of the law which prohibited
dealings for future delivery the bears found their activities
restricted. The law has now been amended, having proved a wretched
fiasco, but in the decade which attended its enforcement it was curious
to note the unanimous cry that went up in Germany for the restoration
of the bear. His usefulness in the stock market no less than in the
commodity market was recognized; his suppression was deplored. It was
found that just as his activities were restricted so the tendency
toward inflated advance and ultimate collapse was increased. The market
became one-sided, and hence lop-sided; quotations thus established were
unreal and fictitious. Moreover there was an incentive to dishonesty,
for unscrupulous persons could open a short account in one office and a
long account in another, and if the bear side lost they could refuse
to settle on the ground customarily resorted to by welchers.
“The prices of all industrial securities have fallen,” said the
Deutsche Bank in 1900, “and this decline has been felt all the
more because by reason of the ill-conceived Bourse Law, it struck
the public with full force without being softened through covering
purchases”--i. e., by the bears. Again, four years later, when the law
was still in force, the same authority states “a serious political
surprise would cause the worst panic, because there are no longer any
dealers (shorts) to take up the securities which at such times are
thrown on the market.” The Dresdner Bank in 1899 reported that the
dangers arising from this prohibition cannot be overestimated “if with
a change of economic conditions the unavoidable selling force cannot be
met by dealers willing and able to buy.”
“Short sellers do not determine prices,” says Professor Huebner. “By
selling they simply express judgment as to what prices will be in the
future. If their judgment is wrong they will suffer the penalty of
being obliged to go into the market and buy the securities at higher
prices. Nine tenths of the people are by nature ‘bulls,’ and the higher
prices go, the more optimistic and elated they become. If it were not
for a group of ‘short sellers,’ who resist an excessive inflation, it
would be much easier than now to raise prices through the roof; and
then, when the inflation became apparent to all, the descent would
be abrupt and likely unchecked until the basement was reached. The
operations of the ‘bear,’ however, make excessive inflation extremely
expensive, and similarly tend to prevent a violent smash because the
‘bear,’ to realize his profits, must become a buyer. The writer has
been told by several members of the New York Stock Exchange that they
have seen days of panic when practically the only buyers, who were
taking the vast volume of securities dumped on the exchange, were those
who had sold ‘short,’ and who now turned buyers as the only way of
closing their transactions. They were curious to know what would have
happened in those panic days, when everybody wished to sell and few
cared to invest, if the buying power had depended solely upon the real
investment demand of the outside public.
“In reply also to the prevalent opinion that ‘short selling’ unduly
depresses security values, it should be stated that ‘short sellers’ are
frequently the most powerful support which the market possesses. It is
an ordinary affair to read in the press that the market is sustained
or ‘put up’ at the expense of the ‘shorts’ who, having contracted
to deliver at a certain price can frequently easily be driven to
‘cover.’ Short selling is thus a beneficial factor in steadying prices
and obviating extreme fluctuations. Largely through its action, the
discounting of serious depressions does not take the form of a sudden
shock or convulsion, but instead is spread out over a period of time,
giving the actual holder of securities ample time to observe the
situation and limit his loss before ruin results. In fact, there could
be no organized market for securities worthy of the name, if there did
not exist two sides, the ‘bull’ and the ‘bear.’ The constant contest
between their judgments is sure to give a much saner and truer level of
prices than could otherwise exist. ‘No other means,’ reports the Hughes
Committee, ‘of restraining unwarranted marking up and down of prices
has been suggested to us.’”[31]
So much for the functions of the bear in markets that deal in invested
capital. In the commodity markets he becomes of even greater value,
indeed, he is well-nigh indispensable. Mr. Horace White, who was the
Chairman of the Hughes Investigating Committee, cites this instance:
“A manufacturer of cotton goods, in order to keep his mill running all
the year round, must make contracts ahead for his material, before
the crop of any particular year is picked. The cotton must be of a
particular grade. He wishes to be insured against fluctuations in both
price and quality; for such insurance he can afford to pay. In fact he
cannot afford to be without it. There are also men in the cotton trade,
of large capital and experience, who keep themselves informed of all
the facts touching the crops and the demand and supply of cotton in the
world, and who find their profit in making contracts for its future
delivery. They do not possess the article when they sell it. To them
the contract is a matter of speculation and short selling, but it is a
perfectly legitimate transaction.
“To the manufacturer it is virtually a policy of insurance. It enables
him to keep his mills running and his hands employed, regardless
of bad weather or insect pests or other uncertainties. The same
principles apply to the miller who wants wheat, to the distiller, the
cattle-feeder, and the starch-maker who wants corn, to the brewer
who wants hops and barley, to the brass founder who wants copper,
and so on indefinitely. Insurance is one of two redeeming features
of such speculation; and the other, which is even more important, is
the steadying effect which it has on market prices. If no speculative
buying of produce ever took place, it would be impossible for a
grower of wheat or cotton to realize a fair price at once on his crop.
He would have to deal it out little by little to merchants who, in
turn, would pass it on, in the same piecemeal way, to consumers. It is
speculative buying which not only enables farmers to realize on their
entire crops as soon as they are harvested, but enables them to do so
with no disastrous sacrifice of price. When buyers who have future
sales in view compete actively with each other, farmers get fair prices
for their produce.”[32]
And, it may be added, the same satisfactory result is attained when
bears who have sold the farmer’s crop short come to cover their short
sales by buying in the open market; their buying steadies the market if
there is a tendency to decline; if the market is strong, their buying
helps make it stronger. In either case they are the farmer’s best
friends, because the farmer profits as prices advance.
Speaking of farmers, it is well known that much of the opposition
to short selling and dealing in futures in the large markets finds
its chief advocates among the Western and Southern politicians whose
constituents are the agricultural classes. These gentlemen fulminate
strongly against the New York Stock Exchange and the grain and cotton
exchanges, and in currying favor with their bucolic supporters they do
not hesitate to condemn margin trading, short selling and every other
phase of speculative markets. Yet it does not occur to them, or, if it
does, they dare not refer to it, that in forming pools and combinations
to hold back their wheat and cotton their constituents are doing the
very thing which they so strongly condemn in speculative centres. The
farmer is, of course, richer than he ever was before, but nevertheless
he grows his wheat to sell, and only a few can carry it for any length
of time without borrowing from the banks. The farmer who goes into
one of these pools with wheat valued at $10,000 and who borrows $8000
on it from his local bank, is nothing more nor less than a speculator
in wheat on a 20 per cent. margin, and the same horrid appellation
describes the cotton-planter who resorts to similar practices.[33]
Now, of course, there is no moral reason why a farmer should not
speculate if he chooses, but what touches us on the raw is his
Phariseeism in doing for himself what he professes to abhor and condemn
in others. One is tempted to say unkind things to the farmer at such
times, to remind him, for example, that he is to-day the most backward
and unprogressive factor in American business life. Despite the fact
that the Department of Agriculture has spent $100,000,000 on his
education in the last twenty years, he has not yet begun to learn what
the German, Dutch, and French farmers learned years ago in intensive
farming, nor has he mastered the art of cattle-raising in anything like
the degree it is understood in the Argentine. Nature has smiled on him;
he waxes fat with her bounty, but he does not keep pace with the growth
of the country. Although enhancing prices are paid him for his product,
he is unable to raise a crop proportionate in any degree to the
facilities put at his disposal in the way of fertilizers and machinery.
One would like to “rub it in” on the farmer, but one doesn’t, “because”
as a recent writer puts it, “the farmer is a farmer, and therefore not
a person to be lectured like a mere banker or broker in Wall Street.”
To the farmer, the politician, and the layman generally, short sales
of cotton or grain are understood, approved, in fact, if the grower
happens to be the one who profits by them. But substitute stocks and
shares for wheat and cotton, and talk of “operations for a fall,” and
the layman thinks he smells a rat. He sees the bale of cotton or the
carload of wheat actually moving; it is a concrete thing; it appeals
to his senses, it is comprehensible. But talk to him of bits of paper
called stock certificates, and by a curious process he concludes
that a short sale has no basis of reality and is therefore menacing
and improper. He persuades himself that short selling ought to be
prohibited by law, and, since Wall Street harbors the chief offenders,
he finds in the nearest politician a handy ally to assist him. These
gentlemen, who obstinately refuse every other medicament, could be
cured of their ailment by a strong diet of economics. They become
subjects of medical, rather than financial, interest. They should dip
themselves into Conant and Leroy-Beaulieu; they should cool off in the
pages of Bagehot and Emery; and, by the time they have got into the
soothing columns of the Hughes Commission’s report, they will be ready
for new points of view.
As a preparatory lesson: suppose a speculator buys from a commission
merchant a carload of coal of a specified grade. The coal is not in
the possession of the commission merchant, but he knows where he can
get it, and he knows that he can deliver it on the date agreed upon.
Accordingly he sells it short, and enters into a binding contract
which, happily, the courts construe to be perfectly legal. Now suppose
the same purchaser wishes to buy 100 shares of Pennsylvania Railroad
stock. All Pennsylvania stock is the same, that is to say any 100
shares of it is just as good as any other 100 shares of the same
property--the number on the certificate is of no importance whatever.
The dealer to whom he applies does not happen to have 100 Pennsylvania
on hand, but he knows where he can get it, and he knows that he can
deliver it to the purchaser on the following day. So he sells it
short, and all that remains to complete his part of the contract is
the actual delivery. He is then a bear on Pennsylvania stock. He may,
if he chooses, go into the open market and buy the stock at once, so
that he will be able to deliver it in the easiest and most direct way.
Or he may feel that by waiting he may be able to buy at a lower price
than that at which he has sold it, hence, in order to make the delivery
promptly, he borrows the hundred shares from one of his colleagues, to
whom he pays the market price as security for the temporary loan of
the certificate.[34] In a day or two the price of the stock may have
declined, whereupon the bear goes into the market and buys the 100
shares of Pennsylvania at a price, say, 1 per cent. lower than that at
which he sold it.
When this certificate is delivered to him next day, he delivers it in
turn to the man from whom he borrowed the original 100 shares; his
security money is then returned to him, and the transaction is closed.
It is just as real a transaction as any other, and just as legal.
Moreover, since it is always possible to buy, but not always possible
to sell, the active presence in the market of large numbers of bears
who _must_ buy, whether they want to or not, is the very best policy of
insurance that a holder of securities could have.
Many years ago there was a law on the French Statute books,
subsequently repealed, prohibiting short sales. M. Boscary de
Villeplaine, a deputy chairman of the association of stockbrokers, was
conversing with Napoleon regarding a pending discussion in the Council
of State looking to the repeal of the law. “Your Majesty,” said de
Villeplaine, “when my water carrier is at the door, would he be guilty
of selling property he did not own if he sold me two casks of water
instead of only one, which he has?” “Certainly not,” replied Napoleon,
“because he is always sure of finding in the river what he lacks.”
“Well, your Majesty, there is on the Bourse a river of Rentes.”[35]
Napoleon felt, no doubt, that there was something inherently wrong
in selling short; even as these lines are written, counsel for a
Congressional committee is attempting to make witnesses admit that the
practice is “immoral.” But why, where, how is it immoral? It pervades
all business; no question of morals or ethics enters into it at all.
The man who sells you a motor-car has not got it; he accepts your money
and enters into an agreement to deliver the car next spring because he
knows or believes that he can make it and have it ready for delivery at
that time. Meanwhile he has sold short. A gentleman of my acquaintance
has sold thousands of storage-batteries on the same basis, although
plans for them have not yet been designed to meet the specifications.
At Cape Cod the cranberry-growers sell their crop before it has begun
to mature; all over the land contractors and builders are “going
short” of the labor and materials which, at some time in the future,
they hope to obtain to fulfil the terms of their agreements. Are all
these worthy people “immoral”?
If it is immoral to _sell_ for a purpose, it is equally immoral to
_buy_ for a purpose; in each case the purpose is the hope of a profit.
Buying for a profit is approved by every one; why not selling? In
both instances you have bought or sold for a difference in price; the
_sequence_ of the events in no way involves a question of morals, since
there is no ethical difference and no economic difference between
buying first and selling last, and selling first and buying last.
Moreover, in selling short you do no injury, since you sell to a buyer,
at his price, only what he wants and is willing to pay for.[36]
All suggestions of impropriety in short selling are grotesque in
their absurdity. But suppose, for purposes of argument, that economic
errors of some sort were actually involved in this practice. How could
it be regulated or controlled? As the governors of the Stock Exchange
stated to the Hughes Commission in 1909, short selling is of different
descriptions. There is the short sale where the security is held in
another country and sold to arrive pending transportation. There is
the short sale where an individual sells against securities which he
expects to have later, but which are not in deliverable form; and in
this connection I call your attention to the recent sale of $50,000,000
of Corporate Stock of the City of New York where deliveries were not
made for a period of about three months, and which stock was dealt in
enormously, long before it was issued.
“If a market had not been provided for it under those conditions,”
said the governors, “the loan could not have been placed. Then, again,
there is the short selling of stock against which different and new
securities are to be issued; the vendor knowing that he is to receive
certain securities at a distant date, but desiring to realize upon them
_at this time_. Beyond this, there is the regular selling of short
stock, either by parties who do so to hedge a dangerous position upon
the long side of the market, or the sale purely and simply with the
intention of rebuying at a profit, should circumstances favor it.”
Finally, there is the investor with stock in his strong-box actually
paid for and owned outright. He may wish to sell in a strong market
with the hope of repurchasing at lower prices, but for reasons of
his own he may borrow the stock for delivery rather than deliver the
securities bearing his own name. Technically he is short; he is a bear.
But in his case, as in that of the others here cited, how can this
perfectly proper method of doing business be “regulated” or interfered
with in any way? I do not think it necessary to pursue so palpable an
absurdity.
It has been said that the bears often resort to unfair methods to bring
about declines in prices, circulating rumors designed to alarm timid
owners of securities and thus frighten them into selling. That this
is done every now and then is undeniable, but the opportunity of the
bear in these matters is very limited, and may be easily and speedily
investigated, whereas similar practices, by the bulls in inflating
values by all sorts of grotesque assertions and promises are by no
means so easily run to earth, and do incalculably more harm.
The bear who drags a red-herring across the trail now and then
interrupts the chase, but he cannot stop it; the genial optimist who
has a doubtful concern on his hands, with a pack of enthusiastic
buyers in full cry at his heels, is a much more serious matter. Good
times and bull markets engender many questionable practices of this
sort. “All people are most credulous when they are most happy,” says
Walter Bagehot; “and when much money has just been made, when some
people are really making it, when most people think they are making it,
there is a happy opportunity for ingenious mendacity. Almost everything
will be believed for a little while, and long before discovery the
worst and most adroit deceivers are geographically or legally beyond
the reach of punishment. But the harm they have done diffuses harm, for
it weakens credit still further.”[37]
If this book were written for people instructed in economic matters
there would be no occasion to dilate upon the usefulness of bears and
the value of short selling, but since we are addressing laymen who do
not understand how the bear can be a useful factor, we may venture to
say once more that insurance is the chief advantage in his operations.
Ex-Governor White’s contribution to the subject, which I have quoted
in this chapter, is strongly supported by Mr. Conant, who shows
that valuable progress in opening new countries and developing new
industries is often made possible by “bearish” operations designed to
“hedge” or insure the new undertaking against loss.
“The broker who has a new security which he desires to place from time
to time in the future, making possible, for instance, the opening of a
new country to railway traffic, protects himself against loss resulting
from future changes in market conditions by selling other securities
for future delivery at current prices. These securities will realize
a profit when the date arrives for delivery if the market has in the
meantime become unfavorable, and will offset the loss upon his new
securities. They will have to be bought at a loss if the movement of
prices has been upward, but the upward movement will afford a profit
upon the new securities which he is seeking to place upon the market.
Thus, to quote Georges-Levy, ‘there is a genuine insurance, which the
broker will have himself organized and on which he will willingly pay
the premium for protection against any accident.’”[38]
An instance such as this serves to show the difference between gambling
and speculating, terms that are often misapplied by critics of stock
markets. A gambler seeks and makes risks which it is not necessary
to assume, and which, in their assumption, contribute nothing to the
general uplift. But the speculator--in the instance just cited, a bear
who sells short--volunteers to assume those risks of business which
must inevitably fall somewhere, and without which the mine, or the
factory, or the railroad could not be undertaken. His profession, and
the daily risks he assumes, call for special knowledge and superior
foresight, so that the probability of loss is less than it would be to
others. If he did not do it--if there were no bear speculators--the
same risks would have to be borne by others less fitted to assume them
or the useful projects in question would not be undertaken at all.
So general is the employment of these hedging or insurance operations
that in the case of cotton--to cite but one instance--the business is
regarded by practically all cotton merchants as an absolute necessity
under modern methods of conducting business. “An idea of the value
of the hedging function may be obtained,” says Herbert Knox Smith,
Commissioner of Corporations, “when it is stated that in Great Britain
banks very generally refuse to loan money on cotton that is not
hedged. Moreover, it is almost universally conceded that, since the
introduction of hedging, failures in the cotton trade, which had
previously been frequent, have been materially reduced as a direct
result of the greater stability with which transactions in spot cotton
can be conducted.”[39]
In conclusion it may be noted that as early as 1732 an attempt was made
in England to prevent short sales by law, that the law was recognized
a mistake and subsequently repealed. To-day there is no law on the
English Statute books restricting speculation in any form. In America
the New York State Legislature enacted a law in 1812 and the Federal
Government in 1864, both designed to prevent short selling. These laws
have also been repealed and they will not be revived. The bear has
come to stay. As a spectre to frighten amateurs, he may continue for a
time to stalk abroad o’ nights; as a necessary and useful part of all
business he is a substantial reality. And he is not “immoral.”[40]