Short Sell This!

First, let’s cut through the nonsense by stating outright that there may be no more honorable or exalted a creature in this world than the noble short seller.  Securities and Exchange Commissioners don’t even come close.

Consider what this brave soul is willing to do, and against what odds:

1. Who else steps in amidst the hype of a high flying, overpriced market and declares: “The Emperor has no clothes” – and puts his money where his mouth is?

2. Where is the investor with the know-how and discipline to study a company’s balance sheet and declare – “This doesn’t add up!”  And hold that company’s feet to the fire?

3. Find me the analyst who can see through poorly managed businesses and has the courage to discipline them by risking his own hard-earned money!

4. Who else possesses the forensic skills to uncover the fraudulent information and accounting gimmickry that the market so regularly overlooks?

Let the short seller be.  And let him take on large positions, that all may come to see when companies hide, lie, cheat and bury information from the public.  The brave short seller deserves our blessings, not our curses.

The short seller is, in fact, our last line of defense against market manipulation.  The sole reason a speculator cannot drive the price of a security ever higher is because the short seller with more information on that stock or commodity (and very often an industry insider) will short the item until it returns to fair value.

Would that we had more such souls, focused on finding overpriced stocks and selling them – and thereby providing much needed liquidity in the marketplace – ensuring buyers a better, fairer price on their trades.

Consider this, too: Wall Street brokerages focus on what to buy and rarely, if ever, issue ‘sell’ calls against a company – at least not until after the stock in question has already fallen precipitously.  And why?  Because they would never again be called upon to underwrite future equity or bond deals for that company!  It’s that simple.  And underwriting is a vastly more profitable enterprise to Wall Street than retail brokerage.  Hence, again, the need for the short seller.

ENTER THE EVIL REGULATORS

The chart below shows just how much short selling has increased over the past decade.  But are we at these record levels because stock prices have been vastly inflated and need to fall more?  Or, as many contrarians suggest, is it a sign of an imminent bullish breakout – one that will be fed largely by a massive dose of short covering? 

July 10, 2008 – Short interest increased to a record 18,125,425,324

There’s no question the shorts will eventually have to cover their sales, but the market will decide when that happens and how much they will either profit or be punished for betting against the tide.  It is not the job of regulators – the true market manipulators – to decide when and how much the shorts should participate in open market activities.

Yet precisely this they recently did.  Against all logic and academic research on the issue (which demonstrates unequivocally that short selling is a benefit to capital markets), the SEC decided that short selling in 19 bank and brokerage stocks would be restricted because were these companies to be “found out” the liability to the U.S. Government would be too great a burden to bear.

So, the Emperor has no clothes, but the public must believe that he does and that they are being well cared for.  Baloney!

And it doesn’t end there.  SEC Chairman, Christopher Cox, reported to the House Financial Services Committee that it was his intention to “extend restrictions on short- sales to the entire market.”

Great!  With no shorts in the market, the bulls will finally run free!  Yahoo!
 
But just remember that what goes up must come down – hard.  With no shorts in the market there’s no holding back the irrational exuberance that leads ultimately to debilitating depression.

Already the evil ones’ work is bearing fruit. Short sales by retail traders like you and me fell 78% on the initial days following the SEC’s Emergency Order.

The chill is on.  And the bank stocks?  Following the July 15th order they responded as can be expected: they rebounded 35% in one week!

But is this reality or an investment dream world?  And where are you going to put your money while the short sellers sit in purgatory?

As we said above, the short sellers will have to buy back their shares eventually, and that will lead to a sharp spike upward in the market – maybe even a new bull leg.  But maybe, too, the good and noble short seller still has more work to do, and more time to wait before he covers.

Take care,

Matt McAbby
Analyst, Charts of the Week