Banning Shorts Works in Fancy Restaurants, Not the Marketplace

by: The Society September 28, 2008 | about stocks: DIA / GLD / QQQQ / SPY    

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By Eric Roseman

A week ago, a host of countries, including some emerging markets, banned short-selling financial stocks. In some areas, they banned short-selling altogether.

The United States Securities and Exchange Commission (SEC) banned shorting 799 financial companies until October 2. In doing so, they're hoping to stem the market crisis unleashed upon financial stocks.

This past Monday, the SEC added another 30 names to the list, including General Electric (GE) and General Motors (GM). This marks the second time since July that the SEC has imposed a temporary ban on shorting financial shares.

By targeting and banning short-sellers, the SEC is barking up the wrong tree and removing one of the last market-based sanctuaries in a dreadful year for financial assets.

This legislation won't help the markets. In fact, it will ultimately create a new round of broad-based selling when the SEC finally lifts the bans. Also, it's possible that bank stocks have already bottomed (at least for this cycle) because a slew of financial indices are now all comfortably sitting above their lows set in mid-July.

Mid-July Might Have Been the Bottom for Financials

XLF Chart

Since the last SEC trading ban expired, two Wall Street behemoths - Lehman Brothers Holdings and Merrill Lynch (MER) have either collapsed or merged with other companies. Obviously, the first ban in July did nothing to help these fractured financial services companies.

The Big Short Squeeze Doesn't Work

This isn't the first time a country has banned short-selling.

Recently in June 2007, Pakistan banned short-selling practices. Now, just 15 months later the market in Karachi is down by another third so that obviously didn't work.

England also banned short-selling in the 17th century following the collapse of the Dutch tulip mania. That effort also failed to calm the markets.

The SEC's ban on financial stock short-selling is primarily why global stocks posted huge gains on September 18 and 19. Short-sellers scrambled to cover their bearish bets or were forced to buy back the same stocks they were betting would continue declining.

This classic "short squeeze" won't help alleviate market sentiment and points blame to the wrong segment of the market. If a company or sector should be valued at a lower multiple, then the government shouldn't interfere in a free market. This response will only delay another day of reckoning as banks face mounting losses on traditional lending practices, including credit cards, auto loans, and other facets of lending.

We Short Because It Makes the System More Honest

Short-selling means you're borrowing shares because you anticipate selling them in the future at a lower price. It allows you to be bearish on stocks that you don't own. From a practical standpoint, short-selling also creates truth in an otherwise corrupt marketplace where some companies dodge accounting rules and fudge their books to hide losses.

The latest salvo fired at short-sellers this month targets the wrong group of traders. These short-sellers actually help to create liquidity in the markets and stem market bubbles.

Short-sellers try to honestly target aggressive accounting practices. And more often than not, these traders help create balance in an otherwise heavily manipulated market.

Short-sellers are also racking up the best returns in 2008 among diversified hedge fund strategies. By some accounts, short-sellers have gained more than 10% this year through August and they're up 12.5% over the last 12 months. In September, estimates point to another 5% gain for this group, while traditional equity benchmarks have crashed by about a quarter.

One of the more respected short-selling specialist firms - Kynikos Associates in the United States - was one of the first firms to isolate questionable accounting at Enron. As I'm sure you heard, Enron CEOs were either prosecuted or heavily fined and will never be allowed to manage a public company again.

SEC Downgraded to Junk - Thanks to Chris Cox

SEC Chairman Christopher Cox has finally awakened from a deep sleep that lasted 13 months. Presidential candidate John McCain publicly denounced Cox last week claiming the first thing he would do if elected this fall is fire Chris Cox. I agree.

The SEC was literally asleep at the wheel until July. They were doing absolutely nothing to police aggressive accounting by financial company CEOs. And they did nothing to warn investors about suspicious accounting, aggressive sales practices involving mortgage-backed securities, or the bubble that inflated among mortgage offerings.

The other high-risk, dangerous securities, including collateralized debt obligations (CDOs), credit default swaps (CDSs), and other credit derivatives are not even regulated, let alone scrutinized by the SEC.

What was the SEC doing all this time as financial markets were hemorrhaging?

Instead of doing its job ensuring that U.S. capital markets are properly regulated, the SEC is now pointing fingers to short-sellers and blaming this highly skilled group of traders and analysts for the markets' crash earlier last week.

Yet Cox, in a public statement earlier in his tenure claimed, "We need the shorts in the market for balance so we don't have bubbles."

Shorting Is American as Apple Pie

By banning short selling the government is effectively saying that it's trying to determine where stock prices should settle. That's not what a free market is about. This response damages the credibility of the free market system and ultimately suppresses the true value of an entity.

If the SEC and other governments can ban short-selling, then one has to wonder which segment of the market is next to face regulation or restrictions...

Is Gold Next?

In 1933, under Executive Order 6102, FDR confiscated gold ownership. Under extreme market circumstances governments can impose extraordinary measures that usually do not benefit the poor, unsuspecting investor.

The current financial crisis in the United States is the worst since the Great Depression and might warrant other measures that confiscate foreign currencies, precious metals, or other international assets and securities. Anything is possible.

As this crisis eventually fades or possibly gets worse, investors should use the offshore private bank account window before it closes. It's still legal to move money to Europe. The best destinations for asset protection remain Switzerland, Liechtenstein, and Austria.

Having some gold stored in these European countries is a powerful safe-haven strategy amid extreme economic circumstances. It will give you the high margin of safety you'll need to protect yourself from the next financial debacle.

Disclosure: None.

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This article has 18 comments:

  •  
    Sep 28 07:38 AM
    Good article. THis market is being outrageously manipulated by the powers that be to try to prevent it from slumping. If you think that's smart well perhaps reflect on everything else they've done so far to contribute to this diabollical situation. In the end the financial chickens will all come home to roost no matter how they try to pervert the process.
    Reply | Link to Comment
  •  
    Sep 28 10:40 AM
    When shorts target a company and grind its share price down, it is an artificial valuation of that company, and have ruined many companiies in that manner. That is wrong and has hurt many individual investors.
    Reply | Link to Comment
  •  
    Sep 28 10:51 AM
    Obviously it's the naked short selling that's the problem. Plus the dropping of the uptick rule.
    Reply | Link to Comment
  •  
    Sep 28 10:59 AM
    Does anyone know how I would move phisical gold to a different country? I'm really interested in something like that.
    Another questiion, do you think Eliot Spitzer was doing a good job before he quit? I dont know much about the subject of wall street, I've learned a lot in the past few weeks reading articles and what you guys comment on. Thank all for the great comments.
    Dave
    Reply | Link to Comment
  •  
    Sep 28 11:07 AM
    qw - shorts, artificial valuation - how come nobody complains when longs push a stock up to crazy levels? What about the investor who buys a stock at 100 that went up from 40 and then goes back down to 40 and the investor loses everything because of the "artificial valuation at 100"? Why is that not criminal? Can someone please explain that to me?
    Reply | Link to Comment
  •  
    Sep 28 12:26 PM
    If short selling allows an investor to be "bearish on stocks they don't own" the obvious opposite position is an activity that allows longs to be "bullish on stocks they buy but don't pay for".

    Of course that is possible through buying call options or sell puts, just as the bearish crowd can either sell calls or buy puts. If bears want to speculate on drops in the stock price then they should use the options market, the same way as the bulls have to.

    So until the system allows bullish investors to buy stocks without paying for them, why should shorts be allowed to sell something they don't own?

    Reply | Link to Comment
  •  
    Sep 28 03:08 PM
    The Vet: People and institutions can be bullish on stocks they buy but don't "pay" for. It's called using margin. People borrow money to buy stocks just as they borrow stocks to sell them for money.

    Banning short selling is not only inconsistent, but it will extend irrational bubbles and make the resulting crashes that much worse - both on the level of individual stocks and indices.

    Any true investor is all for short selling as it leads to more honest prices. Only someone who doesn't know what they own or would sacrifice long-term value for short term gain would want to get rid of short selling.

    Naked shorting is another story though...
    Reply | Link to Comment
  •  
    Sep 28 03:45 PM
    Framing the issue as a yea or nay on short selling is NOT the issue. The issue that the shorts refuse to confront is simply this: Should there be rules that govern short selling? Reinstitute the "uptick" rule and enforce the ban on naked short selling. Shorts do not want those rules reinstituted in the same way that aggressive pitchers in baseball don't like the umpires ban on the "bean ball" (intentionally throwing at the batter's head). Bear raids are made possible because Christopher Cox cut the number of umpires in half and permitted a free-for-all, rapacious, vulgar stampede toward greed. Imagine a game where the men and women carry bats, have rock-hard baseballs, cleats on their feed and NO RULES! How long before there is blood on the field? That is what we have folks. Put the umps back in the game and let's play ball!
    Reply | Link to Comment
  •  
    Sep 28 05:12 PM
    expose...: Perfect!
    Reply | Link to Comment
  •  
    Sep 28 05:22 PM
    large hedge funds can move markets unfairly. I think the practice of short selling should be stopped permanently. It is not a sound practice for the stock market. Big money can squeeze the small investor out. Investing in stocks is about value. Too many retirement funds count on growth to help retirees reach their goals. Tell me how short selling a stock on perhaps weak data is allowing the rich to gain more. How many hedge funds allow small investors in. They don't. My thought is "if you don't own you can't sell it. Gee I wonder who presented this practice to begin with.
    Reply | Link to Comment
  •  
    Sep 28 09:26 PM
    Maybe instead of protecting the Financials from short sellers we should protect the companies that have a smaller pool of stocks. Those are the truely vulnerable companies that hedge funds can aggressively short and do real undeserved damage to.
    Reply | Link to Comment
  •  
    Sep 28 09:36 PM
    Expose, who says shorts are against regulation? Individual investors that use shorting for hedging have no say one way or the other. Exactly as we had no say when government changed short selling rules overnight, causing 10-20% short squeeze. How would you like to loose 20% on a fundamentally sound position just because of government meddling?
    You don't want shorting to be allowed ? Fine. Just warn about the change in advance. It is much easier to work on long side anyway because long-term the market is long biased. Lets all be happy and continue inflating the bubbles. I have no problem with that . I'll be careful to get out on time. Just don't cry wolf when the bubble pops again.
    Reply | Link to Comment
  •  
    Sep 28 11:12 PM
    One way to get physical gold and or silver out of the country, would be through one of the ETF's , although I don't like them, it would work.
    Reply | Link to Comment
  •  
    Sep 29 12:47 AM
    Please explain how re-instituting the uptick rule will add a circuit breaker to the system/All one has to do while shorting a stock is institute a buy on the stock for a few shares thereby having the stock trade at an upwards level and then continue on shorting thereafter.It's called a 'headfake'.How long after the uptick rule(if re-implemented) can one then continue to short?10-20min?1hour?2... do not believe that the gov't should have stepped in to disallow short selling though.The powers that be are RIGGING the marketplaceWhen one shorts a stock it is perceived as anti-american,betting that the stock goes down.On the other hand the uptick rule is a sham also but is perceived in a more favorable light.I recall trying to arbitrage in the mid 70's and was told by wall street houses that it wasn't allowed and now it is commonplace.I believe that short selling has its place in the market and the gov't and regulators are at it again.The market for the stocks that can't be shorted is rigged.Let's start prosecuting all the people rigging the marketplace.Inclusive of gov't officials.The economy benefits as well from this,1) by restoring credibility back into the marketplace,2)criminal attorneys hired to defend the people prosecuted will reap enormous fees and recirculate these fees throughout the economy,3)the gov't will regain credibility as well by prosecuting and weeding out corruption,4)those found guilty will go to jail and their sentences should be harsh enough in order to deter any semblance of activity like this in the future.
    Reply | Link to Comment
  •  
    Sep 29 05:17 AM
    As far as possible, the state must not interfere with the markets. Interference means the insiders and cronies stand to benefit form the sudden regulation.
    I fully agree with the writer's comments on SEC's incompetence.
    Overall, the American people, especially the elite group (top 10%~20%) did not measure up to the mark, hence creating all these mess.

    Avarice has gripped the souls of America. Sacrifice is a word most lacking in their lives.

    Reply | Link to Comment
  •  
    Sep 29 07:13 AM
    Shorting fits with Derivitives. BOTH are evil and detrimental to the honest investor's financial health.
    Reply | Link to Comment
  •  
    Sep 29 10:15 AM
    So who can the little investor who paid $23 plus on Sept 19th, turn to now? Paulson, the gang of "long cheerleaders" on CNBC, you guys on here who are against shorting? If shorting wasn’t banned that day the little investor wouldn't have paid the $23 bucks, it would have never gone there! The government is trying to control the markets which are a rigged game as it is.
    Reply | Link to Comment
  •  
    Sep 29 10:15 AM
    oops my post was about WB
    Reply | Link to Comment
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