Week Ending March 23, 2007o Naked short sales – what you don’t know could cost you plenty.
o Stocks rally as indexes again flash green across the board...
o In spite of the fact that oil rallies above $62/bbl…
o And thanks to softer interest rate language by Bernanke and crew.
o Gold and silver take a breather even as tensions build with Iran.
Last week we talked about more sub-prime turkeys coming to roost and the problems it was creating for the markets. We’re moving on to a new topic this week but on a last note, we were able to locate the link to Jim Grant’s fascinating interview. We include it at the end of this article.
As promised, this week we will be discussing naked shorting and what the practice means to you as an investor or trader. Those who missed the interview can watch it via the link provided at the end of this article. In the U.S. every trading day, $6 billion worth of trades fail. In other words, in $6 billion worth of transactions on American stock exchanges sold each day, shares fail to be delivered. Some of this is due to clerical or data entry error but this is also due to a practice called naked shorting, a practice labelled as “manipulative” by many, where shares are sold short that have not been first borrowed.
Short selling is commonplace on U.S. exchanges and the transaction is initiated by someone who believes share prices will fall. Their goal is to sell the shares now and buy them back later at what the short seller hopes will be a lower price. To do so, they must borrow the shares to be shorted from their broker and a transaction fee is charged by the lender of the shares.
In naked short selling, the seller is able short sell without first borrowing the shares. These shares are sold without incurring the usual transaction cost but the real benefit to practitioners has far more ominous implications for the rest of us. According to the documentary Phantom Shares, large investors and hedge funds are the culprits. But they are getting help from someone (or something) in the system and critics believe its the brokers and/or the Deposit Trust and Clearing Corporation (DTCC) a body that manages these trades.
Why is it important to have a good understanding of this practice and how it works? The simple answer is that it can cost you plenty if you don’t. According to a September 2006 Bloomberg article entitled Games Short Sellers Play more than 425 companies per month may be victims. If you owned shares in these companies while they were being naked shorted, you were also a victim.
Naked shorting isn’t illegal unless one can prove fraud, which is very difficult to do. But the problem for shareholders is that because no share certificates change hands, the naked short seller can sell millions of shares that don’t exist into the market overwhelming buy orders and driving the price into the basement.
Wes Christian, the lawyer representing Overstock.com and more than a dozen other companies that claim their stocks have been pummelled by naked shorting doesn’t mince works when describing the practice. “It’s just plain stealing” he says and he believes it represents the “biggest commercial fraud in U.S. history.”
How will you know if shares of the company you own are being naked shorted? There is no specific naked short data to warn investors that the shares they own are at risk (with one possible exception which we discuss below). The SEC officially forbids naked short sales but puts the restrictions on brokers, not short sellers. It enacted a new regulation called Regulation Short Sales (Reg SHO) in 2005 that was supposed to address the problem by requiring that companies with shares that failed to deliver (FTD) be put on something called a threshold list. Once on this list shares for companies must be delivered within 13 trading days and restrictions are placed on further short sales in that company.
But the fact that the practice continues to occur suggests that there is a loophole and here it is. Shares naked shorted in a company before it was put on the threshold list (and that got the company into trouble in the first place) can remain unsettled indefinitely. This is evidenced by the fact that some companies (like Overstock.com (OSTK) and Martha Stewart Living (MSO)) remained on the fail to deliver (FTD) list for more than 400 days. As of March 24, OSTK had been on the list for 91% of the trading days or 484 days according to Tom Ronk CEO of Buyins.net, a service that tracks short data. (To view the March 24 short squeeze list online, please refer to the link at the end of this article). This situation clearly shows that the practice is still very much alive and well.
Think this is only a problem that impacts cheap stocks? Think again. Of the total of 259 stocks listed in the Buyins.net March 24 naked short list, the average share price is $19.32 per share. They include stocks like Fairfax Financial (FFH) selling at $232.42 per share, Chipotle Mexican Grill (CMG) at $64.80, FirstFed Financial (FED) at $60.26, Pre-Paid Legal (PPD) at $49.95 and even iShares Tr FTSE (FXI) an exchange trade fund containing 10 large Chinese companies including China Mobile and Petrochina with a share price of $102.95.
How do you know if your company is the target of short sellers? Check the number of shares held short for the company (short interest as a percentage of the float). Sources like the Yahoo Finance (finance.yahoo.com) publish total short interest which shows corporate shares shorted that were not yet covered on one day of the month. Buyins.net tracks all short selling in a month, a far more accurate and timely metric of short interest than total short interest.
But the easiest way to protect yourself is using stop losses. If the price begins to drop significantly in lieu of any news, get out and ask questions later.
The good news is that the furor surrounding short sales, and resultant Reg SHO, made more detailed short sales data readily available to the public. This makes it possible for companies like Buyins.net to publish comprehensive reports and this means that it’s now easier to recognize potential short squeezes. A short squeeze occurs when a company’s shares are heavily shorted but then some news or other event (like a great earnings report) occurs that causes massive share buying, driving the stock price higher and in the process putting short sellers underwater.
Figure 1 – Daily chart of Imergent Inc (IIG) showing the SqueezeTrigger level (dashed green line) and Buyins.net buy signal issued September 26, 2006 (green arrow). Over the next five months, the stock rallied 115% even though earnings growth had declined to negative before the signal (red line). Our preliminary research showed that companies with increasing fundamentals (e.g. earnings growth rate) tended to have moves that were longer lasting. Chart by www.VectorVest.com
In an effort to avoid further pain, shorts must buy back (cover) their short positions putting even greater upward pressure on stock price. Buysins.net tracks short sales as well as catalogues the prices at which the shorts begin to encounter pain, a level which they call a SqueezeTrigger. According to the company, once a SqueezeTrigger has occurred there is a better than 80% probability that the stock price will rise. (Please refer to the performance disclaimer page link below). Figure 1 shows an example of a company that has been the target of frequent naked short selling that generated a buy signal in September. One important caveat before looking to take advantage of a potential short squeeze is that the market must be in rally mode. Going long in a falling market increases the risk of losing money.
IIG is an example where a damaging situation can be turned to a benefit, which came about thanks to efforts by folks like Tom Ronk in levelling the playing field for investors. Ronk kindly agreed to send us detailed information on companies that were the subject of shorting and that ultimately became short squeeze candidates so we could track the results for ourselves. We will be sharing those results with you next week so stay tuned. In the meantime, there is link to a slide show presentation which explains the problem in detail entitled The Dark Side of the Looking Glass at the end of this article.
This is another clear example of how what you don’t know about the market can harm you. However, once armed with the appropriate tools and resources, risks to the broader market of uneducated investors can become a distinct benefit to the initiated who know how to use them.
Useful Naked Short Sales Links: Here’s the link to the excellent documentary entitled Phantom Shares about the practice that aired last week in case you missed it http://www.bloomberg.com/avp/avp.htm?clipSRC=mms://media2.bloomberg.com/cache/vIrfhgQPAJ1s.asf or
http://video.google.com/videoplay?docid=4490541725797746038
The Dark Side of the Looking Glass http://www.businessjive.com/nss/darkside.html
Buyins.net short squeeze list for March 24, 2007. http://www.buyins.net/tools/short_list.php?ssd=20070323 .
Document links in the Darkside presentation.
Short Selling Death Spiral convertibles
http://faculty.fuqua.duke.edu/areas/finance/papers/EGMR%205-5-03.pdf
Boni’s Research for the SEC (when we checked it was Forbidden Access)
http://www.unm.edu/~boni/RPAWP/FailsPaperJun25.pdf
DTCC response to naked short selling claims
http://www.dtcc.com/Publications/dtcc/mar05/naked_short_selling.html
Response to DTCC by Robert Shapiro (former US undersecretary of commerce)
Shapiros Response http://www.ncans.net/files/Response%20to%20DTCC%20Deputy%20Counsel%20Thompson%20-%20Robert%20Shapiro%20-%20April%2013%202005.pdf Buyins.net Performance Disclaimer page
http://www.buyins.net/disclaimer.php
As promised, here is the link to the Jim Grant interview. It’s about 16 minutes long.
http://www.bloomberg.com/avp/avp.htm?clipSRC=mms://media2.bloomberg.com/cache/viduDDiIsfZM.asf If you have not seen it yet, it is well worth watching and describes one of the biggest challenges facing a quick fix to the housing bubble.
Now let’s check in on what happened in the stock market this week.
| INDEX | Weekly Close | Last Week | Change | Change% | | INDU | 12,481.01 | 12,110.41 | 370.60 | 3.06% | | DJT | 4,973.27 | 4,781.63 | 191.64 | 4.01% | | SPX | 1436.11 | 1386.95 | 49.16 | 3.54% | | COMPX | 2456.18 | 2372.66 | 83.52 | 3.52% | | RUT | 809.51 | 778.77 | 30.74 | 3.95% |
Summary It was back to green across the index light board as stocks rallied. Even rising oil prices could not dampen the enthusiasm engendered by softer Fed interest rate language that left the door open for a drop in interest rates, even though inflation pressures remain high. Bernanke is has obviously been working on improving his ‘Greenspanese’ and the markets appear to like what they are hearing. Technically Speaking This week the Dow Jones Industrials Average, S&P500, Nasdaq Composite, NYSE Index and Russell 2000 challenged (or broke through) their 50-day moving averages as they rallied higher this week. More importantly from a chart perspective, they are all putting in bullish catapult or W patterns that often portend a strong upside move. In rallying this week, the Dow Industrials posted its best day of the year as it gained 158 points on Wednesday on the heals of the Federal Open Market Committee (FOMC) statement on interest rates.
Commodities continued to trend higher this week as the NYFE CRB Index closed at 405.34 from 399.02 last week.
After rallying for six consecutive days, gold took a breather to close at $657.30 up from $653.90/oz last week. With growing inflationary pressure and the Fed seeming more reluctant to raise rates (could they be getting political pressure with the election looming?) we expect this trend to continue into 2008.
NYMEX crude oil jumped this week to close at $62.28 (continuous contract) up from $58.33 last week as resistance between $62 and $64 is again challenged.
Not surprising given the Fed’s dovish interest rate language this week, it was another challenging week for the greenback as the U.S. Dollar Index closed at 83, up only marginally from 82.94 last week but still mired in a strong downtrend.
The recovery in emerging markets continued with a vengeance this week as the MSCI Emerging Market Index ETF (EEM) rose to 117.03 from 110.25 last week and in the process broke out of a bullish rising triangle chart pattern and up through the long-term up trendline it breached on February 27.
After hitting a high of 20.41 on March 5 (a high not seen since August 2004 when the SPX bottomed at 1060 and subsequently rallied to 1215 by December), the Market Volatility Index (VIX) has settled back down to 12.95 which indicates we are at a temporary bottom at least and investor complacency is slowly but surely returning. Earnings Now that 3946 companies have reported for Q4-06 (up from 3793 companies last week), average earnings improvements over the same period last year held rock-solid at 34% from 29% two weeks ago. This is undoubtedly one big fly in the bear’s correction ointment. Economic Reports It was another average week for economic reports this week. Here’s what the charts had to say.
Chart 1 – After enjoying five months of upward momentum, the National Association of Home Builders housing market index (HMI), a survey of 375 builders, suffered a double blow this month as the February number was revised downward to 39 and the March reading dropped to 36 as the sub-prime and alt-A situation continued to unravel. Breaking the index down into its three components, single-family home sales fell 3 points to 37, sales expectations for the next six months fell 3 points to 50 and the index of prospective buyer traffic through show homes, sales offices etc. dropped one point to 28. Readings above 50 signal expansion while readings below it indicate that builders expect more contractions ahead. Before dropping below 50 in May 2006, the index had remained above it for 10 years.
Chart 2 – Much of the housing industry’s problems can now be traced to “wild and woolly, wholly reckless” lending practices that have dominated the mortgage originations in the last two years as witnessed by the incredible growth in the percentage of adjustable rate mortgages (ARMs) issued since 2003. (*ARMs from 2001-3 averaged 24.6% of the total).
Chart 3 – Housing starts on Tuesday surprised to the upside with a 9% improvement versus a 14.3% drop last month. But housing permits, a better forward-looking indicator of building activity, dropped 2.5% in February and are down 28.6% from February 2006. Looking at the bigger picture, February housing starts are also down 28.6% versus Feb 2006 according to the Census Bureau.
Chart 4 – Existing home sales unexpectedly rose 3.9% in February, the highest monthly gain in 3 years thanks in a large part to improved weather in December and January combined with lower selling prices. This caused the two-year trend line to flatten from down last month. It was not surprising that industry analysts and cheerleaders yet again used this blip to declare a possible bottom in the housing market. Next Week It’s another average week next week for economic reports with three key housing reports to watch.
- Monday, February new home sales (previous -16.6%).
- Wednesday, February durable goods orders (previous -8.7%).
- Thursday, Q4-06 Final GDP (previous 2.2%) and Q4-06 corporate profits final (previous +4.2%).
- Friday, February personal income (previous 1.0%), February personal spending (previous 0.5%), March Chicago PMI (previous 47.9) and February construction spending (previous -0.8%).
Synopsis The market looks to be back to climbing the proverbial wall of worry and there is still lots to worry about. Not only are tensions in the Middle East again heating up, the mortgage situation continues to worsen and the calls to government to bail out those who got in over their heads are getting louder. Any government action at this point will only exacerbate the situation but this doesn’t matter to politicians on Capital Hill bent on painting the image in the media that they are riding to the rescue of hapless citizens (voters) in distress. These politicians are oblivious to the fact that any moves that tighten up lending requirements or punish lenders will only make it more difficult for those voters they are so bound and determined to save to get financial help from the very lenders they are so intent on vilifying.
No matter what the Fed may say, inflation is becoming a more serious problem as evidenced by the real inflation gauges such gold, oil and the other commodities. The current credit bubble with rivers of easy money will continue to create new inflation but handled poorly, this could turn to stagflation and the worst possible of all economic situations. In the meantime however, inflation will be good for stock prices and bad for the dollar.
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All material presented herein is believed to be reliable but we cannot attest to its accuracy. All material represents the opinions of Matt Blackman. Opinions may change without notice and readers are urged to check with their investment counsellors before making any investment decisions. Matt Blackman may or may not be invested in any investments cited above.
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