SEC shooting itself in the shorts?
Posted
Sep 19 2008, 06:59 AM
by
Jon Markman
Rating:
Another day, another stunner on Wall Street, as stocks are on track to levitate briskly following an immediate game-changing adjustment in short-sale regulations by British and U.S. securities officials.
It’s hard to believe that authorities could issue an emergency rule at 3 a.m. that radically changes rules of engagement that have worked well for decades, depriving short-sellers of free-market rights that once seemed inviolate, but that is the slippery path upon which the government has embarked.
SEC Release #34-58592, found here, puts 799 financial services firms on a do-not-short list. The release says the rule is intended to prevent short selling from being used to drive down the share prices of issuers “even where there is no fundamental basis for a price decline other than general market conditions.” The government seems to think this is a necessary adjustment, after being lobbied hard by bank executives, but I think it's a mistake and here's why.
Short selling is the practice of borrowing shares of a company that you expect to falter, and then buying them back at a lower price -- pocketing the difference. Short sellers are largely not the bad guys or buccaneers that they are made out to be in the media; they're mostly people who have studied the fundamentals of a company and found them wanting.
Short-selling is part of the price-discovery methodology of our auction-based markets. When investors determine that a firm's business model is flawed, and as a result earnings are likely to be worse in the future than the market currently believes, then they should have a right to exploit that discovery by selling the stock and making a profit if it falls. It's just as easy for them to be wrong as right. I once asked the great hedge fund manager Michael Steinhardt for his greatest mistake as an investor, and he told me lost a quarter of a billion dollars shorting Cisco Systems in the early 1990s.
Banning short sales is like ordering the media to only print happy news, because reality is bringin' people down. It's like ordering football linemen not to pass rush, because fans prefer to see quarterbacks throw without hindrance. What's next? Maybe ditching the stars on Old Glory and replacing them with a rainbow?
The real problem is that a rule-based rally is unlikely to last. It's a gimmick, not a solution. Here are some facts to ponder.
In the past 11 months since the market top last October, there have been 19 sessions in which roughly 90% of the total volume was down and 90% of the prices were down. That’s a record number of "90% downside days" for a bear market in the past 75 years, according to Paul Desmond at the institutional research firm Lowry’s Reports. Morever there were four 90% downside days in the past 20 trading days, which is a sign of intensifying selling.
Selling alone does not make a bottom, however. Only buying does. And Desmond has discovered that it takes a day of very intense purchasing -- in which 90% of the total volume is up, and 90% of prices are up -- to signal the potential for a lasting market bottom. And the problem on Thursday was that despite the 410 points climbed by the Dow, it was only close to the bar set by Desmond's research, with 88% of the volume on the upside.
Desmond reported Thursday that an advance of this breadth can spark a powerful multi-week rally, no doubt about it. But it is unlikely to mark the start of a new bull market.
Keep in mind that all the 300+ point rallies in the Dow we have had in the past few months have come in the context of a bear market. The entire five-year bull market from 2002 to 2007 did not have a single 300-point up day. These kinds of rallies are only about short-covering, and short-covering is not the same as real buying.
My best estimate, based on research into similar events, is that this rally will be very intense but also short-lived. Since the government has just criminalized short-selling, I think you could get a fast and furious rally up to around the 1,300 to 1,365 level – which is 8.5% to 12% higher – by the end of October. Some banks could go 100%-plus higher than their current prices. But the smart money is likely to take the opportunity to sell all their remaining bank shares into that rally, because the fundamentals of financial firms haven't changed – and in fact they are getting worse.
What’s really important to recognize now is that all the money that the Fed and Treasury are throwing at the banks and American International Group as part of their rescue plans -- which I estimate will ultimately total at least $1.3 trillion – is going into completely unproductive uses.
It is going to shore up holes in balance sheets created by vastly overpaid bank and insurance executives in their misguided quest to build profits by over-lending to people who did not deserve credit. It is like little bits of mortar in the breaking dam of deleveraging. There were $585 trillion in notional value worth of derivatives in the world at the end of 2007, much of which were built on a base of these bad loans. As the loans and derivatives come undone, the $1.3 trillion may end up looking like a band-aid on severed arm.
And that money doesn’t just appear from nowhere. It has to be created via the sale of U.S. Treasuries to foreigners who are already fed up with the way we have mistreated their capital. So those buyers are going to demand a much higher interest rate than Treasuries are fetching now – probably at least 2 percentage points more -- which increases the cost of the funding immeasurably. And all that money could be going to building new factories, research into medicines, new bridges, and new schools. Instead it will go into a black hole that doesn’t create one new job.
Bottom line: The short-selling ban and RTC 2.0 plan should provide an impressive boost for the market for a while, but look for selling to resume by November and new lows to follow.
