Jeremy Warner's Outlook: Markets become short sellers' paradise</i>

No downturn yet, says Daily Mail; Bank's dilemma becomes more acute

As stock markets plunge further into negative territory, there is one group of investors which is sitting pretty – short-selling hedge funds and proprietary trading desks. They've been making a killing out of the market volatility of the last three months.

There is no more fertile territory for short selling than the current environment of fear and uncertainty. Some truly massive short positions are riding on the back of it. Many of them are already seriously in the money.

Is short selling capable of prompting a bear market or precipitating corporate calamities that might not otherwise happen? Though shorting can undoubtedly add to volatility, it should in theory have no net long-term impact on markets.

This is because short positions eventually have to be closed out and the stock bought back. When that happens, shares should bounce accordingly. Shorting, then, adds to both downside and upside pressures, but it is unlikely of itself to cause a bear market. The underlying reason for the current downward trajectory in share prices is an almost total loss of investor confidence. With no buyers in sight, there is only one way for equities to go. There's no knowing how long it will last. Yet for the time being, it's shorting heaven.

One curiosity about the current deluge of short selling is that it is only possible because institutions who are long of the market are prepared to lend the stock. To short sell over any significant length of time, regulators require you to have "borrowed" the stock from someone else so that there is something physical to settle the trade with. There's a fee involved for those who lend, but assuming the shares do as the short sellers want, these fees are nowhere near going to cover the capital loss on the shares that have been lent.

If the institutions are only cutting off their noses to spite their faces by lending, why do they do it? With the pension funds, there are a couple of explanations. The charitable one is that as very long-term investors, they don't care about the short-term ups and downs of the market.

Stock lending just adds a little to the regular stream of dividend income and therefore over time helps boost returns. A less benign explanation is that since most pension fund money does little more than hug the index, the only way managers can distinguish their performance and therefore earn their bonuses is by generating extra sources of return from activities such as stock lending.

Much less easy to understand is why non-pension-fund assets should be lent out in this way. One of the reasons fund managers are able to charge so little for index tracking is perhaps because they can generate additional income from stock lending.

Yet it is hard to see the advantage to the client of obtaining a commensurately lower charge if the effect is to damage the value of the underlying investment. I'm not against short selling, which is an essential part of market liquidity, yet it is hard to figure out why long-only institutions should be falling over themselves to make it so easy.

What's happened with Paragon, the buy-to-let mortgage lender which this week warned that it might need a rescue rights issue, is close to scandalous, with some of the very same institutions which have agreed to underwrite the stock at the same time short selling it in the market in the knowledge that they will be able to close the positions with stock they get from underwriting. This strikes me as not just barmy, but close to abuse.

For the time being, it's a shorters paradise out there. But do those of us who rely on equities to provide us with a pension really have to help in making it so? All long-only fund managers need to be asking themselves some serious questions about their stock lending activities.

No downturn yet, says Daily Mail

The Daily Mail & General Trust share price has looked a bit like the Matterhorn over the past 18 months. After recovering from disappointment over the failed sale of Northcliffe newspapers, the price had been going up like a rocket until the credit crunch started to bite earlier this year. Since then it has been falling like a stone and is now back virtually to the level it was at during the darkest days of the last bear market back in March 2003.

The shares fell another 9 per cent yesterday despite an update which showed profits conforming with consensus forecasts and a reasonably upbeat statement about current trading. Newspaper advertising is a normally reliable lead indicator of any downturn to come.

This is because it is generally the advertising budget that gets chopped first as businesses batten down the hatches for stormier times. Yet there is no sign of this at the moment. The Mail titles are enjoying particularly strong demand from retail advertisers, while local media titles are continuing to see improved recruitment advertising. DMGT's comments are broadly in line with what other newspaper groups have said.

So how come the shares took such a beating? Viscount Rothermere, the chairman, even said he was optimistic about achieving another year of steady profits growth. Unfortunately he also added the rider that this was "provided the UK economy doesn't deteriorate substantially".

In these markets it seems only to require the chairman to admit that he cannot know the future to provide another reason for marking down the share price. To business people, the economy seems fine, but the stock market is already pointing to a significant downturn. We'll see.

In the meantime, it's confirmed that Charles Sinclair will be hanging up his boots next September after 21 years as chief executive. No FTSE 100 boss, other than WPP's Sir Martin Sorrell, comes anywhere close to this record of longevity. In part, it's explained by the fact that DMGT is still a family-controlled company, where continuity and long-term thinking are still valued business concepts. Yet it is also to be fair because he's done an outstanding job in developing the company and diversifying it away from the cyclical UK advertising market.

In what is perhaps a sign of the times, his successor is to be a non newspaper man, Martin Morgan. He's the executive responsible for building up DMGT's successful "information" division, a business-to-business set of operations about as far away from newspapers as it is possible to get while still loosely being defined as "media".

Assuming that you are not the target of his strictures, you'll be pleased to know that despite the rumours, Paul Dacre, the editor of the Daily Mail, will not be leaving any time soon. Yet not even this news was capable of supporting the share price yesterday.

Bank's dilemma becomes more acute

John Gieve and David Blanchflower may not have to wait long to see their counsel for lower interest rates realised. Minutes for the last meeting of the Bank of England's Monetary Policy Committee published yesterday show that though both of them were overruled on the immediate policy decision, with the majority preferring a "wait and see" approach, there was general recognition that with slowing growth, interest rates would soon be on the way down.

Market assumptions of a cumulative reduction of 50 basis points in bank rate over the next 12 months, with a little more thereafter, were considered about right. Yet the main message to be drawn from the minutes was one of profound uncertainty as to the outlook for growth and inflation. The combination of circumstance in financial markets in recent months is described as "unique", making it impossible to draw on past experience of market turbulence as a guide.

Quite what happens if growth is weaker than the Bank anticipates and inflation stronger – all too possible with a sharply rising oil price – hardly bears thinking about. In those circumstances, there is no cutting interest rates to deal with slowing growth.

j.warner@independent.co.uk