Ask any PGA golfer, and he will tell you that bad shots often lead to even worse shots. This is because the first shot leaves you in a worse position than before, perhaps behind a tree, in thick rough or in a sand trap. The next shot is invariably worse because the golfer tries to pull off an exponentially more difficult shot that exceeds his talent, resulting in an even worse position.

 With regard to the SEC’s action regarding short sellers, I believe Chairman Cox is no Tiger Woods. Here is the position short sellers find themselves in:

1. Ban on Short Selling – Part Deux

Despite the miserable failure of the Ban on Short Selling – Part 1, which was the temporary July 21st ban on 19 financial stocks that was designed to protect them from “rumor mongers,” the government has decided to try that shot again, going for even more distance by banning short selling of 799 financial stocks. Interestingly, these 799 do not include RIETs, some asset managers and insurance brokers that are key operators in the current financial debacle. Also missing are certain companies that act like banks, e.g. General Electric (GE), General Motors (GM), and Ford (F). Regardless, it can hardly be the case that short selling in financial companies flew in the face of sound fundamental analysis. Bear Stearns, Lehman Brothers, Fannie Mae (FNM), Freddie Mac (FRE) et al can't blame short sellers for the mess they found themselves in.

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By further restricting the short selling of these 799 institutions, there are a host of consequences. The mother of all short squeezes is underway, not because these short sellers made an incorrect fundamental bet, but because of government intervention. Their fate is now sealed, but other short sellers, hedgers and speculators alike must now ask themselves whether they can rely on a financial system fraught with regulatory uncertainty. To sell short in an environment where the government can change the rules on you literally in the dark of night does not instill confidence in a financial system. Most are aware of the liquidity and hedging benefits that short selling provides any marketplace. Today, short sellers are now operating in a market structure environment equal to the uncertainty of Third World markets.

The irony here is that the short covering that we're seeing today is contributing to higher stocks prices in this morning’s action. A short squeeze is a short squeeze no matter the underlying cause. In a normal world, short squeezes are the result of negative bets on companies that fundamentally are improving. In today’s world the shorts are forced to cover in a panic response to government spasms of regulatory intervention. There is a huge unintended consequence here. Once the short sellers are gone, there will be a cavernous gap between the short covering demand for stock and the demand for stock based upon fundamentals. This vacuum will create a precipitous long squeeze. We saw it in Fannie Mae.


Click to enlarge

The above chart shows the price action in Fannie Mae at the various stages of the original ban on short selling. The stock price got a big bounce after the announcement of the ban, but actually topped out intraday on the day the ban was enforced. By the time the ban was lifted, the price action, reflecting fundamentals, dropped back down to its lows and plummeted thereafter.