Generational Dynamics: Forecasting America's Destiny Generational
 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 16-Jul-2008
SEC blames stock market problems on "false rumors" and "naked short selling"

Web Log - July, 2008

SEC blames stock market problems on "false rumors" and "naked short selling"

Meanwhile, disappointed pundits bemoan Wednesday's market rally.

On Tuesday, July 15, the Securities and Exchange Commission (SEC) issued Emergency order 34-58166 (PDF) that begins as follows:

"False rumors can lead to a loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by “naked” short selling. As a result, the prices of securities may artificially and unnecessarily decline well below the price level that would have resulted from the normal price discovery process. If significant financial institutions are involved, this chain of events can threaten disruption of our markets.

The events preceding the sale of The Bear Stearns Companies Inc. are illustrative of the market impact of rumors. During the week of March 10, 2008, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. As Bear Stearns’ stock price fell, its counterparties became concerned, and a crisis of confidence occurred late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms. In light of the potentially systemic consequences of a failure of Bear Stearns, the Federal Reserve took emergency action. ...

We intend these and similar actions to provide powerful disincentives to those who might otherwise engage in illegal market manipulation through the dissemination of false rumors and thereby over time to diminish the effect of these activities on our markets. In recent days, however, false rumors have continued to threaten significant market disruption. For example, press reports have described rumors regarding the unwillingness of key counterparties to deal with certain financial institutions. There also have been rumors that financial institutions are facing liquidity problems.

As a result of these recent developments, the Commission has concluded that there now exists a substantial threat of sudden and excessive fluctuations of securities prices generally and disruption in the functioning of the securities markets that could threaten fair and orderly markets."

What a pathetic agency the SEC has become, publishing garbage like this. The SEC was created in the 1930s. Its purpose was to prevent any new stock market bubble like the 1920s stock market bubble, with the intention of preventing anything like the 1929 stock market crash from ever happening again.

The SEC totally failed to prevent the huge 1990s dot-com stock market, and subsequently failed to prevent the even huger 2000s stock market bubble based on the housing bubble and the credit bubble. Having failed in its principal mission, the SEC is a total failure as an agency, and is now reduced to issuing regulations that border on gibberish.

Let's just make a few points:

There seems to be no limit to the insanity in today's financial marketplace.


I recently received the following message from a web site reader:

"The article about dumbing down IT was very interesting. it did seem, however, that the ranting almost got a little bitterness in it. I can understand that. I'm a 30 year old IT director, and I get more cynical everyday. What is the generational suggestion to guard my caring heart against that? Prayer is the only answer I suppose. Thanks for a great read."

Every now and then I get a complaint that I'm too "angry," and I can only agree. You wouldn't believe how angry and cynical I am. I've been writing for this web site for six years, and the stench of corruption and fraud -- from politicians, journalists, analysts, financial management, government regulators, and others -- has been overwhelming. After writing this web site for six years, I don't know how I could be anything BUT angry and bitter.

And now we have this garbage from the SEC saying that Bear Stearns collapse -- which occurred after months of provable lying and fraud by Bear Stearns, other financial companies, politicians, government regulators, analysts and journalists -- was caused by "false rumors." Let me apologize to those readers who are offended if they feel that this particular weblog posting is an "angry rant." If it makes you feel any better, I can assure you that the language that I'm using is extremely subdued, compared to the language that I'd like to use.

In response to the person who wrote the message, I wish I had an answer for your caring heart. All I can really do is repeat what I've been saying for years, as this day has approached closer and closer: No politician can stop what's coming, any more than they can stop a tsunami. You can't stop what's coming, but you can prepare for it. Treasure the time you have left, and use it to prepare yourself, your family, your community and your nation.

I'll be posting an article tomorrow giving specific advice and suggestions.

And now, back to our story.

Short selling

If you think that a stock price is going to go up, then you can buy shares today and sell them later, thus making money if you were right. That's called "going long" or "buying long."

If you think that a stock price is going to go down, then you can sell shares today (even if you don't have any shares to sell) and buy them back later, thus making money if you were right. That's called "going short" or "short selling."

In the typical case, the short seller doesn't have any shares to sell, and so he has to borrow some shares, paying a borrowing fee of about 0.2% of value of the shares. (By the way, borrowing fees have been increasing recently to as much as several percent, because of increased demand for borrowed shares for short-selling.)

So, in a typical case, there are four people in a short sale: The Trader who wants to short-sell, the Broker, the Lender who lends the shares, and the Buyer who buys the lent shares.

The Trader tells the Broker that he wants to short-sell for, say, three months. The Broker borrows some shares from the Lender, paying a borrowing fee on behalf of the Trader. The Buyer buys the lent shares, and the Broker puts the sale proceeds into an account on your behalf. At the end of the three months (or at any time before), the Trader can "cover his shorts" by purchasing shares to replace the ones he borrowed. If he was right, then the shares he purchases will be cheaper than the ones he sold, and he'll make money.

Short-selling is considered a perfectly acceptable practice, and has been for centuries.

Naked short selling

When a Trader and Broker execute a short-sale, they must obtain shares to be sold. The Broker may already own such shares, and can use those in the short sale, or the shares may be borrowed from a Lender. The rule is that the shares must be obtained and settled within three days.

If the shares are not provided within three days, it's called "failure to deliver." If the Trader never had any intention of providing shares, it's called "naked short selling."

Naked short sales are sometimes perfectly legal. For details, see SEC Regulation SHO, which gives examples of short sales and naked short sales that are legal.

However, naked short sales are illegal when their intent is to manipulate the market by driving the prices of shares down. The way this is supposed to work is that a large hedge fund registers a huge short sale for a particular stock, with no intention of borrowing the shares. The huge short sale looks like a sale to other investors, who panic and sell their own shares, thus driving the price down.

The SEC's new emergency regulation prohibits even those naked short sales that were formerly legal. However, this change only applies for the rest of the month, and only to short trades involving a specified list of financial institutions.

Apparently the intent is to see how this short term regulation works, and that will determine whether the regulation will be extended.

Pundits have been going nuts over this regulation. CNBC's Jim Cramer did a 5-minute on-air rant, waving around a piece of paper which he claimed was the SEC regulation that said that naked short sales have been illegal all along. However, that claim is wrong, as can be seen by reading Regulation SHO, referenced above.

Is the market plunge caused by naked short sales?

The SEC has failed to provide even a single credible example where naked short sales have driven share prices down.

The SEC, which has totally failed in its primary mission, is now looking for other people to blame. This is quite standard procedure, especially for government officials.

In fact, after the market crashed in 1929, a lot of people blamed the crash on short sellers. Here's a description from John Kenneth Galbraith's 1954 book The Great Crash - 1929:

"The decline had run its course. However, the end coincided with one last effort at reassurance. No one can say for sure that it did no good. One part was the announcement by the New York Stock Exchange of an investigation of short selling. Inevitably in the preceding weeks there had been rumors of bear raids on the market and of fortunes being made by the shorts. The benign people known as "they," who once had put the market up, were now a malign influence putting it down and making money out of the common disaster. In the early days of the crash it was widely believed that Jesse L. Livermore, a Bostonian with a large and unquestionably exaggerated reputation for bear operations, was heading a syndicate that was driving the market down. So persistent did these rumors become that Livermore, whom few had thought sensitive to public opinion, issued a formal denial that he was involved in any deflationary plot. "What little business I have done in the stock market," he said, "has always been as an individual and will continue to be done on such basis." As early as October 24 [Black Thursday in 1929], the Wall Street Journal, then somewhat less reserved in its view of the world than now, complained that "there has been a lot of short selling, a lot of forced selling, and a lot of selling to make the market look bad." Such suspicions the Exchange authorities now sought to dispel. Nothing came of the study." (p. 136)

In the end, the new investigation into short sellers is just as meaningless as the one in 1929. It allows government regulators to project the appearance of doing something, but in reality they're doing nothing.

Should you try short-selling?

Several people have criticized me for writing that short selling is dangerous because brokers' escrow accounts would be in jeopardy during a market crash that drover brokers into bankruptcy.

The situation that I envisioned was the following: The Trader (you) initiate a short sale. The Broker borrows stock, and sells it to the Buyer for, say, $100,000. The Broker keeps the $100,000. Now suppose the market crashes and falls 40%. You purchase back the shares for $60,000, and you've made $40,000. But suppose that the Broker goes bankrupt. Then you might lose the $100,000, and you'll end up still having to pay $60,000 to cover your short position.

A web site reader wrote to me as follows:

"That's not how it works. You keep confusing brokerage funds with customer funds. The $100,000 belongs to the customer, it goes into the customer's account, it is invested into whatever the customer wants to invest it in, most likely a money market fund. The money market fund most likely consists of US Treasuries which have no default risk (because once again, the government cannot technically go bankrupt, they are the ones that spend (create) money into existence, money that is backed by nothing)."

And so I put the question to an online correspondent into these things. He replied that the $100,000 would go into a segregated account that would be safe if the Broker went bankrupt during a market crash.

He provided some very technical additional information about what might happen if the market meltdown occurred while the short transaction was still being processed:

"As far as your question, yes, in the event of a market meltdown, any funds already present in a segregated futures account prior to the meltdown are safe. As I understand it, the funds are non interest bearing US dollars which are not dependent on the integrity of any underlying financial instrument. What would likely happen after any large and sudden financial meltdown is that the short would have a credit due on their position that would not be paid in normal fashion due to the fact that the long accounts would not have sufficient funds to sweep in the amount due....

Any trades consummated during the meltdown would work in the same manner. The customer's margin would be wired directly into the segregated account, but any profit on short positions taken during the meltdown would be subject to sweeping the available money out of the long accounts and there would likely be a shortfall in the case of a severe multi sigma (we could say) type of meltdown. As far as the brokerages, I seriously doubt what your correspondent is saying is correct, but ... I know of no brokerage that uses a treasury (t-bill) only money market account as their default account for customer funds. Any of the default money markets I have looked at are chock full of ABCP [asset-backed commercial paper] and other junk."

So I think the moral to this story is that if you have a very, very strong stomach, and you're willing to take some risks, then you might make a lot of money short-selling across a stock market crash, but you really have to know what you're doing. What's absolutely crucial is that you have to keep track of your money ($100,000 in the above example) and know where it is every minute. That money is the greatest potential source of disaster in short-selling into a market crash.

Incidentally, don't forget that short-selling can be disastrously expensive even during a "normal" transaction while in a bear market. The market today (Wednesday) rallied 2˝%, and if you had shorted the market, you would have lost a great deal of money.

The capitulation fantasy grows in importance

Market summary, 15,16-July-2008
Market summary, 15,16-July-2008

Pundits were happy on Tuesday, when the Dow Industrials fell 92 points, because they were sure that the market couldn't go much lower, and that capitulation was near.

One pundit wrote, "Capitulation is nigh!":

"Panic is in the air. ...

"[S]ome capitulation activity has been accelerated and the likelihood of an intermediate bottom forming today, tomorrow or Thursday is now over 95 per cent."

As we've previously said, the capitulation concept is a fantasy. It supposedly will occur after everyone sells off, giving up any hope that the market will go up again. At that point, goes the fantasy, the market will go up again.

The logical paradox is that everyone is expecting capitulation to occur after a couple of sharp market plunges, which will mean that everyone's given up hope. But since everyone knows that that means capitulation, everyone will expect the market to go up again, so capitulation hasn't occurred after all. So capitulation can never occur.

CNBC's Sue Herrera points to the word "Turmoil" in the Washington Post headline <font face=Arial size=-2>(Source: CNBC)</font>
CNBC's Sue Herrera points to the word "Turmoil" in the Washington Post headline (Source: CNBC)

But what I found interesting on Wednesday is the pathetic desperation in people's voices, asking each other, "Is this capitulation?" Here's one of many examples, from CNBC anchor Sue Herrera:

"We obviously read all the newspapers every morning, and this one caught our eye in a big way. I'm gonna hold it up, because there's a key word here. This is the Washington Post -- almost the entire front page is dedicated to the economy, and I'll point you to the word, right here, which is "Turmoil." an economy thrown into turmoil. Is that indeed the case? ...

If you look at the Washington Post and some of the magazines and some of the headlines, we could be looking at a point of capitulation. ...

This could really be a sign that we're near the bottom."

The capitulation fantasy is obviously growing, and is going to a major feature in the attitudes of investors.

Corporate earnings

I wrote the other day that the latest earnings update had mysteriously not appeared on the CNBC Earnings Central web site. Well, it did appear finally on Tuesday afternoon, and here is the resulting table:

  Date    2Q Earnings estimate as of that date
  ------- ------------------------------------
  Jan  1:              +4.7%
  Feb  6:              +3.5%
  Apr  1:              -2.0%
  Jun  6:              -7.3%
  Jun 13:              -8.1%
  Jun 20:              -9.0%
  Jun 27:             -11.3%
  Jul  3:             -12.4%
  Jul  8:             -13.0%
  Jul 11:             -14.7%

As usual, corporate earnings estimates have fallen significantly for another week. Once again, this will push price/earnings ratios up higher, and that will cause formula-driven investors to sell off, driving the stock market down further. Well, at least there's some good news: That will make the "capitulation pundits" happy.

The second quarter earnings for financial services firms are starting to come in. Wells Fargo came in higher than expected on Wednesday, and that's one of the factors contributing to the Wall Street rally. JP Morgan Chase & Co. will be reporting on Thursday morning, and Merrill Lynch will be reporting late Thursday afternoon.

These financial service firm earnings will probably determine the short-range direction of the market. If they're better than expected, the market will go up, at least for a while; if they're as bad as expected, or worse, the market should continue going down.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (16-Jul-2008) Permanent Link
Receive daily World View columns by e-mail
Donate to Generational Dynamics via PayPal

Web Log Pages

Current Web Log

Web Log Summary - 2016
Web Log Summary - 2015
Web Log Summary - 2014
Web Log Summary - 2013
Web Log Summary - 2012
Web Log Summary - 2011
Web Log Summary - 2010
Web Log Summary - 2009
Web Log Summary - 2008
Web Log Summary - 2007
Web Log Summary - 2006
Web Log Summary - 2005
Web Log Summary - 2004

Web Log - December, 2016
Web Log - November, 2016
Web Log - October, 2016
Web Log - September, 2016
Web Log - August, 2016
Web Log - July, 2016
Web Log - June, 2016
Web Log - May, 2016
Web Log - April, 2016
Web Log - March, 2016
Web Log - February, 2016
Web Log - January, 2016
Web Log - December, 2015
Web Log - November, 2015
Web Log - October, 2015
Web Log - September, 2015
Web Log - August, 2015
Web Log - July, 2015
Web Log - June, 2015
Web Log - May, 2015
Web Log - April, 2015
Web Log - March, 2015
Web Log - February, 2015
Web Log - January, 2015
Web Log - December, 2014
Web Log - November, 2014
Web Log - October, 2014
Web Log - September, 2014
Web Log - August, 2014
Web Log - July, 2014
Web Log - June, 2014
Web Log - May, 2014
Web Log - April, 2014
Web Log - March, 2014
Web Log - February, 2014
Web Log - January, 2014
Web Log - December, 2013
Web Log - November, 2013
Web Log - October, 2013
Web Log - September, 2013
Web Log - August, 2013
Web Log - July, 2013
Web Log - June, 2013
Web Log - May, 2013
Web Log - April, 2013
Web Log - March, 2013
Web Log - February, 2013
Web Log - January, 2013
Web Log - December, 2012
Web Log - November, 2012
Web Log - October, 2012
Web Log - September, 2012
Web Log - August, 2012
Web Log - July, 2012
Web Log - June, 2012
Web Log - May, 2012
Web Log - April, 2012
Web Log - March, 2012
Web Log - February, 2012
Web Log - January, 2012
Web Log - December, 2011
Web Log - November, 2011
Web Log - October, 2011
Web Log - September, 2011
Web Log - August, 2011
Web Log - July, 2011
Web Log - June, 2011
Web Log - May, 2011
Web Log - April, 2011
Web Log - March, 2011
Web Log - February, 2011
Web Log - January, 2011
Web Log - December, 2010
Web Log - November, 2010
Web Log - October, 2010
Web Log - September, 2010
Web Log - August, 2010
Web Log - July, 2010
Web Log - June, 2010
Web Log - May, 2010
Web Log - April, 2010
Web Log - March, 2010
Web Log - February, 2010
Web Log - January, 2010
Web Log - December, 2009
Web Log - November, 2009
Web Log - October, 2009
Web Log - September, 2009
Web Log - August, 2009
Web Log - July, 2009
Web Log - June, 2009
Web Log - May, 2009
Web Log - April, 2009
Web Log - March, 2009
Web Log - February, 2009
Web Log - January, 2009
Web Log - December, 2008
Web Log - November, 2008
Web Log - October, 2008
Web Log - September, 2008
Web Log - August, 2008
Web Log - July, 2008
Web Log - June, 2008
Web Log - May, 2008
Web Log - April, 2008
Web Log - March, 2008
Web Log - February, 2008
Web Log - January, 2008
Web Log - December, 2007
Web Log - November, 2007
Web Log - October, 2007
Web Log - September, 2007
Web Log - August, 2007
Web Log - July, 2007
Web Log - June, 2007
Web Log - May, 2007
Web Log - April, 2007
Web Log - March, 2007
Web Log - February, 2007
Web Log - January, 2007
Web Log - December, 2006
Web Log - November, 2006
Web Log - October, 2006
Web Log - September, 2006
Web Log - August, 2006
Web Log - July, 2006
Web Log - June, 2006
Web Log - May, 2006
Web Log - April, 2006
Web Log - March, 2006
Web Log - February, 2006
Web Log - January, 2006
Web Log - December, 2005
Web Log - November, 2005
Web Log - October, 2005
Web Log - September, 2005
Web Log - August, 2005
Web Log - July, 2005
Web Log - June, 2005
Web Log - May, 2005
Web Log - April, 2005
Web Log - March, 2005
Web Log - February, 2005
Web Log - January, 2005
Web Log - December, 2004
Web Log - November, 2004
Web Log - October, 2004
Web Log - September, 2004
Web Log - August, 2004
Web Log - July, 2004
Web Log - June, 2004

Copyright © 2002-2016 by John J. Xenakis.