Sunday, July 20, 2008

Naked Shorts are not a wardrobe malfunction.

An alternative headline could have read, "What was the most important thing that happened this week to change the direction of the markets?" Here is my list, you choose what you think:

The President decided to suspend the executive order banning drilling for oil on the outer continental shelf.

Oil failed to break $150 a barrel.

The Fed decided to let the two mortgage giants shop at the Fed window.

THE NAKED SHORT RULE IS GOING TO BE ENFORCED.

All the above.

If I were forced to choose only one from the above, I would say all the above, but if you force me to choose something other that all the above I would say THE NAKED SHORT RULE.

You may ask why I choose this one above all the others, because this one item changed the tone of the market, and it will take some of the manipulation out of the market. Notice I did not say speculation, I said manipulation.

I say that there is a big difference between speculation and manipulation. You ask what is the difference? If one wants to speculate that a stock will go down, they sell short by borrowing stock and then selling it in the market. If they are right then at some point in time they will go back into the market buy back the stock and deliver the stock to the person they borrowed it from originally. They sell at one price and hope to buy at a lower price in turn making the difference. An example might be to sell short XYZ at $20 per share and at sometime later buying XYZ at $10, therefore making a $10 per share profit. In order to make this transaction happen you have to find broker/dealer that has the stock to lend to make the short sale. These short sale rules have been around for longer than I have been in the business and they worked. In order to have a market you need people who think that the stock price will go up and people who think the stock price will go down.

So, how does this form of shorting which is legal differ from naked shorting? Naked shorting is selling something short and not having the stock to deliver to cover the short position. If the dealer cannot deliver the stock to short, the firm must notify the short seller to deliver the stock from some other dealer or the trade will be sold out. The total number of share that can potentially be shorted is equal to the shares outstanding. I find it hard to believe that it could ever go to 100%, but that is the potential.

Naked short positions may become equal to an amount great than the number of share available to buy putting tremendous pressure on the market price of the stock. If you do not have to deliver the shares, the number of shares that can be shorted is limitless. This is the problem that caused the SEC to act to have the dealers in force the existing rules. Some of the dealers were not demanding the shares be delivered to complete the transaction under the rules, therefore you had a naked short transaction. When the SEC said that it was ordering all primary dealers to enforce the rules, people began to scramble to cover their short positions. If you have more buyers than sellers the price has to rise and that is what happened this week. If you have more short positions outstanding-- greater than the float people are scurrying to find stock to cover their positions. There will be special limits going into effect on Monday the 21 of July for selected financial stocks that have heavy naked short positions. I believe the SEC waited until Monday to allow naked short sellers some time to try to unwind their positions.

This rally may have another 400 to 500 points to run, 11,900 to 12,100 on the Dow Jones before it runs out of gas, no pun intended, and starts down again. Look at the quality of what you own, take any rallies to raise cash and reposition your assets to a higher quality asset. Scroll down and look at my forecast for oil and gold before the end of the summer they may yet still be right.

Dan Perkins