US & Canada

Why short sellers, and carpenter ants, are good for us

Image caption Ants may chew your rafters - but alert you to a bigger problem in the process

Short sellers have something of a bad press. Often accused of driving stocks down ruthlessly to make a quick profit, they are actually a misunderstood breed - and we should all be thankful for them.

When a piece of my roof fell off, I knew I was in for a bad day. I pulled out my ladder and climbed up to see what the problem was.

That's where I found a nest of carpenter ants that had eaten through my eaves and were starting to tunnel into my rafters.

Cursing a blue streak, I called a roofer and was still cursing when he arrived to give me an estimate on fixing the damage. But the roofer didn't think the ants deserved my invective. In fact, he claimed they had done me a favour.

A favour?

"The rotten, little insects are eating my house. How is that doing me a favour?" I demanded.

Due for a crash

The roofer explained that carpenter ants only eat rotten wood. My real problem wasn't the ants - it was a leaky shingle which had allowed water to soak into my rafters.

By eating the waterlogged wood and making a hole big enough to catch my attention, the ants had revealed the damage and saved me from even greater damage, like a collapsed roof six months down the line.

I had to admit he had a point.

I was reminded of this incident recently while listening to a discussion of short sellers on the radio.

Short sellers make money by betting that a particular stock or investment is over-valued and due for a crash.

To make that bet, the short seller sells a stock he doesn't own. He sells for what he thinks is an inflated price and hopes the crash comes before he is contractually obliged to deliver the stock to the buyer.

If it works, he'll buy the stock at a much lower price than he sold it for and pocket the difference, foisting the damaged goods off on the poor buyer. It's a blatant attempt to part a fool and his money.

Described that way, it's no wonder short sellers are as popular as carpenter ants. But there is another way to look at it.

Something rotten

Image caption A ratchet is built into the market if sales only take place when someone thinks a stock is going up

Like carpenter ants, short sellers concentrate on weak areas in the economy.

They are much more likely to attack an over-hyped company or an over-inflated sector. That's where the potential for profits is highest and where their strategy is most likely to pay off.

By adding a bit of pessimism to the market, short sellers help find and pop bubbles.

Without short selling, transactions can only take place when someone thinks a stock or asset is going to go up. This builds something of a ratchet into the market and enables all sorts of pathologies.

Momentum bubbles that keep going up because they have been going up, for example, and "Bigger Fool" investing where someone buys a stock he knows is over-valued on the theory that he'll be able to find a bigger fool who will be willing pay even more.

Short sellers put the brakes on runaway momentum and increase the risk that the Bigger Fool investor might end up being the biggest fool in the market.

By putting a bit more loss into the profit and loss equation, they provide incentives for prudence and give the economy a bit of ballast.

If bubbles are bad, we shouldn't blame those who help pop the bubble for the pain of the aftermath any more than I should have blamed those ants for my leaky shingle.

Instead we should pay attention to them because, wherever they are swarming, there's probably something rotten under the surface.

Something rotten we need to know about.

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