Monday, September 22: The Day the Contrails Faded

Hedge Fund Regulation 21 Sep 2008

Climate researchers have long debated the effect of airplane contrails on the average ground temperature.  They theorized that contrails prevented sunlight from hitting the ground and warming the lower atmosphere.  But while each individual contrail could, in theory, create a slight shadow over a wide area, it was impossible to really gauge the effect of these ubiquitous clouds on the overall climate unless people literally stopped flying for several days.

Of course, this is exactly what happened during the week of September 11, 2001.  And researchers subsequently discovered that contrails did affect climate after all.  As CNN reported at the time, the average temperature volatility in the US actually rose significantly:

“During the three-day commercial flight hiatus, when the artificial clouds known as contrails all but disappeared, the variations in high and low temperatures increased by 1.1 degrees Celsius (2 degrees Fahrenheit) each day, said meteorological researchers.”

The recent moves by the SEC and FSA to curtail shorting of financial stocks provides researchers with a similarly unique opportunity to examine the effect of this equally ubiquitous phenomenon.

Academics have theorized that shorting causes increased market volatility – particularly downside volatility revealed in the negative skew of market returns. A 2004 study by Arturo Bris, William Goetzmann, and Ning Zhu of Yale concluded that countries with no short-selling restrictions (in green below) had less negative skew than countries with rules preventing short-sales (in red).

The skew of each country’s market returns is captured by the horizontal axis on the chart below. The vertical axis shows the extent to which each market is “efficient” at pricing individual securities. (Click the chart to enlarge it.)

A number of the countries in this study removed short-selling restrictions during the period of study. As a result, they appear on the chart twice – once before short-sale restrictions were lifted (in red) and once after (in green). This gave the authors a unique opportunity to explore the effect of shorting while keeping most other factors basically the same.

What they found seemed match the general findings above:

“We separately study the five countries in our sample that changed their short sales regulation and practice during the sample period-Hong Kong, Norway, Sweden, Malaysia, and Thailand-using an event-study methodology. Even though restricting the sample to only five countries implies a drastic reduction in degrees of freedom, using these countries obviates the need for most controls. We find significant increases in efficiency, and in the negative skewness of market returns, once short sales are allowed and practiced in these countries.”

Early returns from Friday suggests that the curtailment of shorting has given equities a serious boost, to say the least. But unlike the natural environment, the stock market is often a self-fulfilling prophecy. So it’s difficult to know if the market is anticipating less downward pressure from shorts or is actually feeling less downward pressure from shorts.

Regardless, research says that banning shorts comes with a cost – market efficiency.  Still, policymakers are more likely to put the cuffs on market efficiency and throw it in the back seat of their squad car.  As Bris, Goetzmann, and Zhu point out:

“Our analysis of the statistical characteristics of markets, specifically the skewness of log returns, provides some interesting support for the commonly held regulatory view that short sales restrictions are associated with less negative skewness in market returns.”

Addendum: Texas and California aren’t waiting around for the SEC to ban shorting. Instead, they decided to stop lending out stock to those who they believe are essentially depressing the value of their long-only portfolios. The Dutch are of two minds on the issue – realizing that lending stock is a lucrative business – especially when regulators make it more difficult.

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  1. JBarton
    September 23, 2008 at 5:44 pm

    The “no contrails” analogy for the short selling ban will no apply until the existing short interest has been covered. Shorts provide natural demand to balance long selling. When there is no short interest, we will see if long selling doesn’t increase volatility when it has no natural offsetting demand from shorts.

  2. Alpha Male
    September 23, 2008 at 6:34 pm

    Valid point. But I wonder if the lack of new shorting is the salient thing here. In other words, has the effect of the existing short positions already been factored into current prices? In fact, does the covering of existing short positions give stock prices an artificial tailwind? And if so, what will happen when there are no more shorts to cover?

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