STATICRHETORIC

by C.S. Jefferson

I cannot believe that commentator and media analyst alike, one after the other, is publicly professing outrage over the new short selling restrictions recently implemented by the SEC emergency action. They smirk and seem to take great pleasure at pointing to the 300 plus, nearly 400 point sell off on Monday, and the follow through on Tuesday’s trading sessions as proof and example that short selling restrictions don’t work. Really?

You don’t mean to say that you actually believed that by removing the ability to short stocks that the market couldn’t trade down, did you? Because if you did, then none of these so-called “experts” even deserve to have the pulpit or mouthpiece to speak with any measure that is credible beyond a bedtime fairytale.

If you watched the selling on Monday or Tuesday, it was the first time I had ever seen such an orderly sell off without the panic inducing disruptions of forced liquidations across the board. And that’s how markets should behave, orderly, not necessarily up or down with directional bias.

In addition, the overall market was trading on relatively light volume and because of that, the price action could be arguably more exaggerated by the move. But what you didn’t have was short sellers and funds coming in and pounding the markets by aggressively amplifying the downside pressure. I would also say that another reason for a sell off, and why there weren’t that many buyers in the market, was that they were the very same ones that bought last week and Monday was more or less “profit taking,” if you could call it that, from the huge recovery late last week.

Remember back to ancient history of, let’s say last week, when we were in serious crisis Thursday morning, sub 10,600 on the DOW and plummeting fast with no end to be seen? Goldman Sachs (GS) and Morgan Stanley (MS) were on the verge of going under like their predecessors in the investment banking sector, despite the fact they just reported net positive earnings. And the viral contagion of the credit collapse was about to spread to the other pillars of our financial system. Something had to be done to save our economy from a complete and systemic disaster.

We didn’t get back to where we are without the largest “short squeeze” ever in history orchestrated by the Treasury, Fed and SEC in conjunction with global short selling rules and restrictions. Short selling restrictions brought an end, as intended, to the bank run on the markets last week. This doesn’t mean that everything is finally resolved back to normal levels of confidence in the markets, but it did buy time to pass legislation for the Paulson plan.

Now, to be clear, if Congressional leaders fumble the ball and don’t support a plan of action to address the current credit crisis, then we have serious problems and, at that point, I would have to reevaluate my optimism in the markets.  And, surely, if the SEC lifts the restriction on short selling by allowing the ruling to expire in October, look out, ’cause short sellers will try to hit the markets with a vengeance.

THOU DOTH PROTEST TOO MUCH

Don’t be fooled, short selling restrictions do work. In fact, before Monday’s trading session, the argument against short selling restrictions was that prices would be artificially inflated or that it would be impossible to determine price discovery. And that short sellers provided a service to the markets by revealing overvalued companies so that investors wouldn’t overpay.

Right, should you believe the very same hedge funds that complain about something when they have so much to lose? I hope professional short sellers get blown out of the markets and locked out of the casino from further manipulation or capitalizing on other people’s misery. Think about it, logically, and consider the source. When professional short sellers start complaining about the rules, then they must be working. Who cares, it’s payback for bulls and what’s wrong with trampling on a “bear-skinned rug?” If very successful professional short sellers like Jim Chanos and Doug Kass complain the loudest, Shakespeare would suggest: “thou doth protest too much.”

Seems like people forgot the basic theory of economics 101, that something is only truly worth what someone else will pay for it at current market value. In the case of stocks, price discovery mechanisms are determined through meeting the spread between the bid and the ask. If no one is willing to pay the current ask price, then the price will fall if there are no bidders in the markets. Likewise, if the bid overwhelms the current availability at the ask price, then prices will rise.

Seems markets work fine to me without the exploitive pressure of short selling volumes pushing price action artificially down. That is the function of capitalism and “free markets,” without the manipulative abuses of short sellers tossing gasoline on the fire.

To me, professional short sellers–and I am making the obvious exception for market makers and liquidity providers–are like arsonists running around torching people’s homes to collect the insurance money. They induce panic by talking down the markets from their own book, and use tremendous volumes of sell orders to hit the legitimate bids in a stock over and over until they exhaust any support levels as the price falls.

I have no problem with prices falling because there is less demand for the stocks, but I do have a problem when there is this “hit list” by professional short sellers that are, literally, targeting solvent companies and driving them into bankruptcy. That behavior is not only un-American, that is unpatriotic and immoral, most importantly, it is definitely not free markets and Capitalism.

And if someone doesn’t think a company is valued correctly, then make your bet by using a “synthetic short position” by shorting calls and buying puts through the options markets. That’s fair, and I would use those techniques myself if I feel a company is overvalued and trending down, but your decision to short a position should not be predicated on the capacity for manipulation, or the inside ability to eventuate the final outcomes in the stock.

MARKET MAKERS AND LIQUIDITY PROVIDERS MUST HAVE AN EXCEPTION TO THE RULE

I’ve mentioned this before in a previous article but, to be clear, market makers and liquidity providers should be excluded from short selling restrictions so, yes, there is some legitimacy to the argument that market makers could not properly offset risk by the service obligation of providing liquidity in the market.

For those that don’t understand how this works, when you buy put protection and a market maker sells you that contract, they must, in turn, short the underlying shares to hedge their position. And the same is true if you sell a call and a market maker buys the option contract, they must short the underlying shares against the position. In effect, they are creating a neutral position that offsets risk in order to create tremendous liquidity in the markets and tight spreads on the bid and ask. They do this over and over again throughout the day to create liquidity and, essentially, utilize “gamma scalping” of premiums through very minute and precise arbitrage.

I am concerned, however, that there are market makers that also trade for their own firm’s interest. I would hate to think that this exception to the short selling rule for market makers is just another “back door” for institutions to short sell stock and drive prices down further. A lot of firms that do their own proprietary trading with their own self-serving interests also provide liquidity as market makers which could, potentially, be a severe conflict of interest. I have no problem with market makers shorting for the exclusive reason to provide liquidity in the markets, but if it becomes a loophole around the intended effect that is, whether you like it or not, working to blow out professional short sellers and hedge funds, then you tell me who has the bigger fix in the game.

So, in theory, market makers could be the back door or exception to the rule. Technically, a fund could target a stock by buying extraordinary amounts of long put contracts and forcing market makers to hedge risk by shorting the underlying stock, essentially, bypassing the rules to use liquidity providers as the surrogate for the fund’s original intention to drive prices down. Such intentions should absolutely be illegal if done in a concerted effort to manipulate the markets and, in all seriousness, could be difficult to prove in the end.

LIMIT UP, LIMIT DOWN

Quick note on Monday’s oil action in the futures markets. Crude spot prices jumped over $16 to settle at $120.92 at the close based on no fundamental reasons at all. This was blatant manipulation. Yes, it was a short squeeze against open and existing October contracts due to expire imminently. With extreme backwardation and price dislocation because of the November contract that was rolling over to the new spot price the very next day that didn’t reflect the squeeze. Only about 30,000 contracts traded, less than 1/10th of normal volume and less than the November contract of nearly 300,000, which was trading at a much lower price.

Regardless, the CFTC needs to regulate this or governance needs to occur so that we cannot allow oil to be pushed back toward 150 without breaking the back of the American economy. The fundamentals are not there to justify such price manipulations and it is financial impairment to the livelihoods of all Americans.

If you ever wanted proof of manipulation in crude prices, this was it and it’s there for everyone to see, even if you put your blinders on and didn’t know how read Braille…

This entry was posted on Tuesday, September 23rd, 2008 at 8:07 pm and is filed under POLITICS, DIATRIBES AND EDIBLE RANTS, TRADING AND INVESTMENT STRATEGIES, U.S. MARKETS AND THE GLOBAL ECONOMY. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.