Pitfalls in Today’s US Stock Market – Part 1

Wednesday, May 26, 2010

Yesterday, I described two professional investment management approaches.

  1. When opportunities arise in emotional times, buy
  2. Sell short (and incite); then buy

The first is not only sound investing, it provides the means for generating liquidity in tough times, a key element to the long-term health of our public ownership system. The second is the opposite. It seeks higher gains for the few at the expense of many. By creating instability and fear, it undermines investors’ and public companies’ trust in the system. Today, I want to discuss the #2 approach:

I.   How it works

II.  Why it is allowed to exist

III. What we can do to protect ourselves

I.  How it works

The goal is straightforward: Scare investors into selling at abnormally low prices, then buy. There are three steps involved:

1. Pick a problem and sell short, both to take a bearish position and to create a negative price picture
2. Help spread negative commentary (including false rumors) to unnerve, even frighten, investors into selling
3. Buy when selling drives prices down, closing out the short sale and going long at the artificially low prices

II.  Why it is allowed to exist

(Personal note: For me, this was a challenging part to write. I want to stay objective, but the subject generates strong, negative emotions. The destructive missteps the SEC has made, and continues to make, have fostered much of the volatility and angst investors have experienced in recent years. It removed controls on Wall Street’s harmful game playing that was effectively stopped in the 1930s.

I had thought that the smash-up we’ve had to live through would see a return of those well-designed rules. Instead, in perhaps a face-saving tactic, the SEC has created pathetically weak “modern” rules that will do nothing except prevent an absolute catastrophe from occurring in a single day.

Exacerbating these weakened controls is the allowance of unregistered, enormous, secretive hedge funds. They have the willingness, size and privacy to pull off the same tactics that had been previously outlawed.

In spite of these adverse conditions, I know we can invest and succeed. However, the risks are greater and the system is missing important investor protections – as well as protection for organizations whose securities are now subjected to Wall Street’s game playing.)

For our financial system to work, all parties (particularly issuers of securities and investors in those securities) must feel that the markets will operate above board, producing reasonable prices with adequate liquidity in virtually all market environments.

To have a sound financial system, rules and regulations are a must. Markets, left to their own devices, can be manipulated. And, where large money is involved, can be means will be. Therefore, as in any game, rules must be established to ensure no individual or group can take advantage of another.

For example, “insider trading” is banned, yet it is discovered periodically. The reason is that the potential returns are so large, some are willing to risk being caught. Without the rules, non-insiders would be at a serious disadvantage.

There are a number of other games that can be played, and, unfortunately, the SEC has allowed the following to return:

Short-selling at any price, not just on an uptick.

The 1938 “uptick rule” was removed in 2007 after the SEC made a poor study that excluded common sense and a historical perspective. They thought modern sensibilities would prevent the return of robber baron tactics. However, human nature and money’s allure remain the same, so back came these two previously dead games that use unrestricted short-selling as a tool:

  • “Painting the tape” through price manipulation – trading (buying, selling and short-selling) to create a false pattern to entice or frighten investors
  • “Bear raids” in which short-sellers slam a stock, trying to create panic selling by others, thereby allowing the short sales to be covered profitably at lower prices

“Naked” short selling, without needing to borrow the stock first

Even Christopher Cox, SEC head in 2007 when the uptick rule was removed, said naked selling was “a fraud that the commission is bound to prevent and to punish.” Nevertheless, it was later allowed to occur for specious, administrative reasons. This brought back:

  • “Watered stock” in which new securities are effectively printed and sold, thereby increasing the supply without registration or disclosure. Combined with the lack of an uptick rule, a bear raid’s effectiveness is compounded.

German Chancellor Angela Merkel’s remarks say it best:

“The lack of rules and limits [on naked short selling] can make behavior in financial markets driven purely by the profit motive destructive and lead to an existential threat to financial stability in Europe and even the world. The market alone won’t correct these mistakes.”

Spreading false rumors

False rumors can heighten investor emotions by providing apparent, albeit fake, rationale for the price moves. The SEC has had the challenging responsibility of identifying false rumors and prosecuting those who spread them. Nevertheless, in 2008, “The Securities and Exchange Commission announced on Sunday that it and other regulators would begin examining rumor-spreading intended to manipulate securities prices.” (“S.E.C. Warns Wall Street: Stop Spreading the False Rumors,The New York Times, by Stephanie Clifford and Jenny Anderson, July 14, 2008).

The way “news” gets circulated nowadays, and the willingness to report information without corroboration from independent sources, means it’s easier than ever to plant misleading information. The disconcerting fact is that the SEC said it “would begin” (when did it stop?) checking in earnest in July 2008 – too late for Bear Stearns:

“… rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. Notwithstanding that Bear Stearns continued to have high quality collateral to provide as security for borrowings, market counterparties became less willing…. … The market rumors about Bear Stearns liquidity problems became self-fulfilling.”

SEC press release – Letter from Christopher Cox to Basel Committee on Banking Supervision; March 20, 2008

I’m going to stop here for today. Tomorrow, I will get into the changes in exchange trading and the role hedge funds play in all of this. Then we will cover the ways we can protect ourselves.

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John Tobey on Seeking Alpha

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May 2010