Brief excerpts from our August 18th issue
By Alan M. Newman, Editor, Stock Market CROSSCURRENTS | 20 August 2008
A 300 Point Dud?
Merrill Lynch’s David Rosenberg recently claimed a 300 point daily gain in the Dow has never occurred in a bull market. Jim Bianco at www.biancoresearch.com, confirms that there have been 24 rallies of at least 300 Dow points since September 8, 1998 and seven since September 18, 2007. According to Bianco, "during the 2000 to 2002 bear market, the DJIA had 15 days where it gained more than 300 points. The first was March 15, 2000 (five days after the NASDAQ peaked) and the last was October 15, 2002, near the bottom of the bear market. During the 2002 to 2007 bull market, the DJIA had no days where it gained more than 300 points."
Seems clear to us. If anything, the huge rally of August 8th likely means the bear is still in control. Worse yet, only [5] trading sessions remain until September, typically the worst month of the year. For over a century, September has risen less than 39% of the time as measured by the Dow Industrials… No other month has been up less than half the time, not even October. If you’re looking for a downside catalyst, look no further than the financial issues. It’s Katy Bar The Door time. Again.
Where Will The Axe Fall Next?
It took a lot to open the eyes of many observers, but the collapse of Bear Stearn's shares and the near fatal runs on Fannie Mae and Freddie Mac acted as a signal alert of a painfully obvious aspect of our markets: the short sale mechanism as currently practiced is horribly broken and is in dire need of repair. It is not only so-called "naked" short sales, in which shorted stock has not been borrowed from a legitimate owner and so cannot be delivered to the buyer on the flip side of the short sale; in fact, all short sales contribute to dilutions wherein more shares trade than companies have authorized.
As a result of continual heavy shorting, upside price prospects diminish simply due to the dilutive effects, a totally mechanical influence that exists despite the accuracy or inaccuracy of the bearish case. Moreover, the removal of the uptick rule that was in place for 74 years allows shorts to pile-on and drive down prices, another mechanical effect that exists despite any validity of the bear case. If this is difficult to comprehend, just exchange the mechanics of the short sale for the long side and let’s call it "momentum investing." That was sufficient to give us a veritable mania and Nasdaq 5000. Downside mechanics can be every bit as emphatic.
We have argued a patently obvious situation previously; that the current market maker exemption allows "naked" short sales in quantity, diluting corporate stock. We even illustrated a situation in which shares cannot be legitimately borrowed but instead, Put options are purchased, enabling roughly equivalent downside bets. Market makers are then legally permitted to hedge their exposures by shorting shares without borrowing, nor delivering them to the purchasers on the buy side of the short sale transaction.
In essence, shares are created where none are supposed to exist. In any short sale, a similar situation occurs. Additional "owners" exist due to short sales[[eg, those "owners" who purchased the "shorted" shares— even if legitimately borrowed: normxxx]]. Corporations are forbidden from selling additional shares without going through the arduous legal processes required to "go public," yet the actions of brokers and market makers have produced a nearly identical effect. Clearly, the playing field is not level. Our major financial media either ignore the problem or make light of a situation we believe is destined to test our markets again in very short order.
In a recent NY Times column (see http://tinyurl.com/5rgvym), Floyd Norris asks if the SEC's temporary action to curb naked short sales actually helped and answers, 'maybe, maybe not'. Importantly, Mr. Norris notes the bottom for financial issues was coincident with the SEC's action but also suggests the connection "could mean nothing." Since the SEC allowed the new rules to expire last week, we believe the proof is likely to occur in the next couple of months. As long as the SEC continues to park its collective head up its rear end and ignore the patently obvious abuses, the risks to our market will continue unencumbered by sanity. The axe will fall again.
Required reading for all investors and traders: http://tinyurl.com/5t7um9. Gary Matsumato's August 11th Bloomberg article details the implosion of Bear Stearns as viewed by several observers who know a thing or three about how the markets work. To wit; "Peter Chepucavage, a former general counsel for compliance at Nomura Securities and onetime SEC lawyer, said the Bear Stearns bets were neither smart nor lucky. 'When you buy $5 strikes when the stock is trading over $50, you either have to be manipulating, or you have to have insider information.'" To answer the question of premeditation in the death of Bear Stearns, the SEC must subpoena the trades and the parties to the trades. The longer this question remains unanswered, the more harm befalls our markets.
We repeat, the SEC is deaf, dumb and blind, seemingly unwilling to take on the world’s most powerful and influential lobby in a meaningful manner. We note with caustic skepticism that Bear Stearns was not a party to the LTCM bailout in 1998. When push came to shove and Bear was asked to participate in 'saving' our markets, they demurred [[they wanted no part of a mess they hadn't made: normxxx]]. Was this payback time? Stay tuned for "Bear-Trap: The Fall of Bear Stearns and the Panic of 2008 (Hardcover)," written by Anonymous, to be published next month.
We first commented on naked short sales four years ago and over the last year have attempted on numerous occasions to point out how the current short sale mechanism is flawed in its entirety. For the supreme irony, cast your baby blues at the table below, which details both the total number of shares authorized by the companies listed and the total number of shares held ONLY by large block owners, which clearly does not include the shares held by you, your Aunt Emma, your children and possibly your pension fund. For the seven major financial institutions listed, 15.4 billion shares are entitled to trade, yet a total of 19.8 billion somehow 'exist'. Despite the obvious impossibility of this situation, 30% more shares are trading than there should be.
The U.S. stock market suffers an extraordinary problem, one that has the potential to rupture the system, as the close calls with Bear Stearns, Fannie Mae and Freddie Mac proved. One week ago, the NYSE announced that short interest through July 15th had risen another 2.7% during the first half of July to 18.61 billion shares, representing another record high going back to 1931. Close to one of every 20 shares trading on the NYSE are currently sold short. Total short interest has doubled in the last two years and has risen a dramatic 44% in just the last year, coinciding with the SEC’s elimination of the uptick rule.
Both Goldman Sachs (GS) and Washington Mutual (WM) have 45% more shares held by "large block owners" than the company has authorized in total. What is the point of corporations authorizing any limits on the issuance of shares if the limits can be so easily circumvented? The combination of corrupt short sale mechanics, rumor mongering, a collaborative industry and a grossly inept SEC have brought us to the brink. We’d be surprised if the rally continues. There’s just too much temptation and opportunity out there for shorts to kill the market. And unfortunately, it’s much too easy.
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Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
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