With the Fourth of July this week, it’s about time this column celebrated the true unsung patriots of the free market — short sellers, who speculate against stocks they believe to be overvalued. Without them, fraud and manipulation would go unpunished and the free market would be a corrupt sham.

Short sellers have a bad historical reputation, and intuitively one can see why. If Merrill Lynch is bullish on America, then short sellers are, by definition bearish on America and are thus in some sense subversive.

In the aftermath of the 1929 crash, it was thought by the U.S. Congress and other unsophisticated thinkers that the crash itself had been caused by short selling. Thus the Securities Act of 1933 included a number of protections against short sellers, including the intellectually bizarre “uptick rule” by which it was illegal to sell a stock short except immediately after an upward move. Naturally, this rule, which is still in effect, hindered legitimate short selling while not inhibiting manipulators in the least — they just manipulated the system by pushing through a small buying order before a much larger selling one.

Much of the intellectual detritus of the 1930’s — Bauhaus architecture, admiration of Stalin, a belief that government was more efficient than the free market — has, thank goodness, been consigned to the dustbin of history, but suspicion of short selling is still with us, and hence the activity needs to be examined more closely.

Short selling differs from ordinary stock purchasing in that it is much riskier, for two reasons. First, the theoretical loss on a short position is infinite — while a drop of 50 percent is huge, a rise by 200 or 300 percent in a volatile stock is quite possible, and so a short seller can certainly lose far more money than a buyer for the same net exposure.

As the great 19th century speculator Daniel Drew is reputed to have said: “He who sells what isn’t his’n, Must buy it back or go to prison.”

Second, in order to carry a short position, it is necessary to “borrow” stock from another broker, so that stock can be delivered when the short sale takes place; this borrowing is generally considerably more costly than an ordinary bank loan because of the limited supply of stock and limited number of stock “lenders,” hence making short selling very expensive indeed if the position has to be held for a substantial time.

With the exception of the inevitable flotsam of amateur speculators that get washed out by the first unexpected bull run, short sellers are thus generally knowledgeable and are speculators rather than investors, because of the cost to them of holding for a long period.

In general, short selling is not a particularly profitable business — one thinks of the famous 1920’s and 1930’s “bear” Jesse Livermore, who ended up destitute in 1940 after a decade that, based on the market’s overall behavior, should have been uniquely lucrative for him.

Livermore’s failure illustrates well both the theoretical basis and the shortfall of short selling. In general, short sellers are “value” investors; in other words, in the same way as Warren Buffett but in the opposite direction, they seek to discover hidden values in the stocks they trade — in the case of short sellers, hidden overvaluation.

The huge disadvantage of this approach for short sellers is that, as Livermore discovered, values need not correct themselves immediately. In Livermore’s case, he lost money waiting for stocks to drop in the latter stages of the 1920’s boom, and then lost money again by buying on margin in 1931-32, when he felt that the market fall had gone too far — instead of rebounding, the market dropped still further.

There is however, a corresponding advantage to short selling that is not available to a value investor on the “long” side. A value investor buying stocks is seeking stocks that the market has undervalued, that have earnings, assets or prospects greater than the market has perceived. In this, the value investor is on the same side as company management. Consequently, the published information about the company being invested in generally reflects the values being sought, and the value investor’s job is simply one of better analysis than his competitors in the market.

On the short side, the position is different. In general, there are two potentially profitable situations for the short seller; the situation where the underlying company is of value, but the stock market has indulged in an orgy of speculative overvaluation, and the situation where the company itself is worthless or fraudulent. The latter case, if it can be detected, is potentially much more profitable and less risky than the former.

In the former case, the short seller is not researching something unknown, he is researching something that is very well known by other investors, and may indeed be extremely popular. Hence he is always running the danger summarized by the title of Charles Mackay’s 1851 classic “Extraordinary Popular Delusions and the Madness of Crowds.” If the delusions remain popular, and the crowds remain mad, the stock may go on climbing, and the short seller may lose his shirt. Many such sad stories were told in the great 1996-2000 bubble, and have been told in every bubble since the great South Sea inflation of 1720.

In the case of fraud, or, even without outright fraud where the underlying company is worthless, the short seller’s position is much stronger. Here, the short seller, through diligent research, has discovered something that nobody else knows about and that company management is trying diligently to hide: that a company that is well thought of in the market, in fact has poor prospects, a product which does not work, or financial statements that misstate profits through accounting chicanery.

This is the short seller’s value to society, which has been surprisingly little recognized. He keeps the market honest. Without him, it would be in everybody’s interest for news of defective products, mis-stated earnings and outright fraud to be swept under the rug while the retail investor, either directly or through badly run mutual funds, buys overpriced securities that insiders want to get rid of.

The short seller’s interest is to counteract this, to publicize the defects, misstatements and frauds as widely as possible (once he has acquired his short position) in order that others may sell and the stock drop.

Short sellers do not flourish in the big investment banks where the possibility of offending providers of issue business is too great. Instead, they typically operate through small brokers and “hedge funds,” often undercapitalized, that exist at the margins of the financial community. A recent book “Sold Short” by professional short seller Manuel Asensio (which UPI will shortly review), outlines their techniques by means of “war stories” and demonstrates that the life of a short seller is exciting — and intellectually stimulating if you like running counter to the big battalions (including the New York Stock Exchange itself, whose fees are paid by listing companies, not short sellers.) It is however, by Wall Street standards, not especially lucrative.

Nevertheless, the short-seller’s activity is a vital market discipline, and one which has been seen too little in the tech bubble of the last few years. Through it, capital is drawn away from the overpriced and the fraudulent, and reallocated to sounder investments where the short sellers are not active. This is wholly beneficial for the economy; there can be no health in an economy where the meretricious are as capable of attracting capital as the sound.

As I said, short sellers are the true patriots. They engage in an activity that is very dangerous and not particularly lucrative and cleanse the market of hype, error and fraud.

This July 4, let us in the annual parade salute short sellers, and not the stock market bubble blowers of Merrill Lynch and their ilk.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.