No THIS is the Mother of All Short Squeezes…

In the aftermath of the SEC’s decision to finally start enforcing Regulation Short Sales (RegSHO) on July 15 by banning naked short selling in 19 banking and financial stocks, I wrote an article entitled Mother of All Short Squeezes.  In it I made the following comments.

“In their monthly Short Interest Report on July 16, Bespoke Investment Group updated their short interest numbers showing that short interest as a percentage of the float continued to increase during the second half of June with the average short interest hitting 6% for the S&P 500. Over the last year, short interest has increased 48% for the 500 stocks. Bespoke also found that the 10 percent of stocks in the S&P 1500 with the highest short interest (150 stocks) gained 15.1% in the two day period ending July 17, 2008 compared to just 2.2% for the 150 stocks with the lowest short interest.”

“Not surprisingly given the government bailout plan announced this week, Fannie Mae (FNM) and Freddie Mac (FRE) enjoyed the biggest lift jumping 89.5% and 74.5% between July 15 and July 18. But as of the July 18 close, they were still down 61% and 72% in the last four months (since March 20).” 

The article discussed some of the other beneficiaries of the incredible short squeeze that was occurring in financial stocks that week.

Bespoke also found in a study of rallies in the last five years that the decile of most heavily shorted stocks (those with the highest short interest as a percentage of their float) experienced the greatest gains. The painful downside however, is that the most heavily shorted stocks also led the market to the downside during a correction or bear market.  

It’s nearly mid-night on the West Coast and Bloomberg has just announced that the SEC is joining the British Financial Services Authority (FSA) in banning shorting of all financial companies (as opposed to naked shorts which the SEC attacked in January 2005). Problem is, the SEC never really put much effort into enforcing RegSHO that is until this week when it was forced to play catch-up when markets turned truly ugly.  

These moves in London and Washington follow a similar action in Moscow to ban short selling by the Russian government in an effort to calm panicky markets. Many including yours truly think it adds even more credence to the axiom that the term 'government intelligence' is an oxymoron. But the real question is, will it work?

Figure 1 – Weekly chart of the S&P500 showing short squeeze that resulted in the week of July 18 (green arrow) with sudden action by the SEC to ban naked short selling in 19 banks and financials. Also note that like the Dow Jones Industrial Average and DJ Utilities Average that have both put in bearish head & shoulders chart patterns, the SPX looks its trying to do so too. Chart by GenesisFT.com

As we see from figure 1, the decision to ban naked short selling in 19 financial companies July 15 by the SEC caused a huge short-covering rally but as we also see, it was short-lived.  

As we wait to see how the crew aboard the SEC Titanic will rule on such instruments as put options and how they will deal with inverse or bear ETFs in which money managers short stocks to provide profits, markets will undoubtedly rally and it should be at least as powerful as the one in mid-July.

But if history is any guide and we are in a bear market, it's a move that will prove to be short after which stocks are likely to return to their familiar journey to lower prices. 

However, this action reveals one unpleasant reality and that is that minions at every level of government, from regulator to political candidate, share a common goal.  No action, regardless of how costly or disruptive to long term stability, will be considered too drastic in the futile attempt stop the bursting of asset bubbles. 

And finding a scapegoat is a big part of the larger bureaucratic strategy of trying to gain public approval in a crisis. However, like the misguided attempt to stop bubbles from bursting, it is an effort that will ultimately prove futile.