Get Shorty

“No one loves the messenger who brings bad news.” Sophocles

Good Evening: U.S. equities rebounded today amid a flurry of news and non news stories that ran the gamut. Earnings reports, M&A, a further extension of the TARP, minutes of the March FOMC meeting, and proposals by the SEC for changing the short-selling rules all vied for investors’ attention, and it was tough to tell just which of them had the most impact on stock prices. I place the SEC’s short-selling proposals in the non news category, since it will be months before any rules changes become effective. Like the FASB move to ease mark-to-market accounting rules, however, this latest attack on short-selling practices seems to be yet another attempt to shoot the messenger.

Market participants and investment bankers alike have long been waiting for the drought in Mergers and Acquisitions to end. Disappointed that the gathering clouds around a potential combination between IBM and Sun didn’t precipitate a deal, investors looked to the skies in thanks over the news early this morning that Pulte would buy homebuilding rival, Centex. Bankers hope the trend sparks other strategic combinations, or at least enough deals to shower their depleted departments with fees.

Also before the bell came reports that a new patch would soon be added to the ever expanding quilt formerly known as the TARP. Insurance companies with bank subsidiaries will likely become eligible for the dubious honor of receiving government aid via the program, which was originally conceived to buy the troubled securities now plaguing the asset side of insurance company balance sheets. When a company like Berkshire Hathaway gets downgraded by the ratings agencies, the weather must be pretty heavy for lesser insurers. And yet, I wish the insurance industry would better avail itself of private capital solutions (as with a reinsurance product I’m working on — call me if you want details) rather than look to taxpayers for support. Hmmm. Banks, auto makers, and now insurers — Uncle Sam is building quite the diversified portfolio, isn’t he?

The news boosted various insurance stocks, and, along with the Pulte/Centex announcement, pushed stock index futures from red to green prior to the opening bell. An early 1% pop was met with enough selling to drive the averages back to the unchanged mark after one hour of trading. The firm price action among companies delivering earnings news helped revive the tape, though. Alcoa shook off last night’s earnings miss and went up, while Bed, Bath & Beyond and Juniper rose on an earnings beat and a slightly positive earnings pre-announcement, respectively. Exhaustive chatter on television about the potential reimposition of the “uptick rule” also provided a tailwind and the major averages were up some 2% in the early afternoon.

Equities then received a bit of a reality check at 2pm edt when minutes of the March FOMC meeting were released (see below). Previously looking for an economic rebound in the second half of ’09, the Fed’s economic staff pushed out its estimate for recovery until 2010. Responding to this darker outlook, the FOMC downgraded the economy (“downside risks predominating in the near term”) and upgraded their direct purchases of Treasurys and MBS by a cool $1.15 trillion. Known previously as “printing money” or “monetizing debt”, the politically correct reference for these expansionary efforts by our central bank is now “quantitative easing”. Market participants seemed to react to the economic forecast first and took stocks back to unchanged with just under an hour to go, but those hoping the QE program will some day work helped bid up equities into the closing bell.

In finishing with a gain of only 0.6%, the Dow was the dog of the day, while the 2.4% rise in the Russell 2000 was best in show. Treasurys were unperturbed by the equity rally due to another dose of the aforementioned quantitative easing. As if to put an exclamation point on its own minutes, the Fed bought almost $3 billion of short dated coupons today. Yields were flat to down 4 bps as the curve flattened a bit. The dollar was also little changed, as were commodities. Crude oil inventories rose a touch less than expected, helping to push the energy complex higher for a second straight day. A modest rise in precious metals also chipped in as the CRB index was up a modest 0.4%.

As I reported to work at the Chicago Board of Trade on a brutally cold day during the winter of 1983, I was confronted by a swarm of picketing protesters. This motley crew of farmers had driven to Chicago from various Midwestern towns to voice their anger with the “evil speculators” on LaSalle street. They were especially mad that the CBOT allowed traders and investors to sell short various grain contracts in the futures markets, repeatedly bellowing that “people shouldn’t be allowed to sell what they don’t own! They are knocking down crop prices and hurting farmers!”

I tried to tell one of the protesters that a combination of good growing weather in 1981 and 1982 and a deep recession during this period was at the root of the halving of corn, wheat, and soybean prices from their late ’70’s highs, but they would have none of it. Only hedgers (e.g. farmers & grain co-ops) should be allowed to sell short, they told me; everyone else should be banned. My short explanation about free markets and the liquidity benefits provided by speculators on both sides of the market fell on deaf ears. I left them standing in the cold and went inside wondering how they could be so dumb.

I was grateful in the ensuing years to transition my career to the financial side of the CBOT and was proud to be among those who thought the overseers of all things financial would never be stupid enough to impose something like the short-selling ban hankered for by that group of farmers. I was first proven wrong a few years later when “program trading” was straight-jacketed after being blamed for the 1987 crash. Then, in 2008, the SEC imposed — overnight — a ban on the short-selling of a host of financial companies. Today, the SEC said it is considering a range of proposals to limit short-selling (see below). Everything is on the table, from so-called “circuit breakers” to a reimposition of various forms of the old uptick rule that was abandoned in 2007.

Let me be clear that I am no fan of abusive practices like “naked short-selling” or market manipulation. They are both illegal and should remain so. Better enforcement of these rules, stiffer fines, and real penalties for the broker dealers who allow clients to break these rules should be enough to prevent abuse, but not these days. We are now in the action phase of the blame game, and the shorts are easy targets. Even President Obama’s choice for Chair of the SEC, Mary Shapiro, admits the evidence that short-sellers harm our markets is thin to non existent:

“The SEC isn’t aware of any ’empirical evidence’ showing the elimination of the uptick rule contributed to ‘volatility’ in U.S. stock prices, Schapiro said. Still, ‘many members of the public have come to associate short-selling with that volatility and with a loss of investor confidence,’ she said.” (source: Bloomberg article below)

Ah, volatility. Now we come to the real reason short-sellers are criticized by the media and demonized by Jim Cramer. They don’t like the message lower prices bring, so now they want to “fix the problem” by restricting short-selling. Not discussed, as usual, is how small the short-selling community is compared to their opposite numbers, as well as the increased liquidity available to all when more players are putting capital at risk. The uptick rule was in place for decades, but it somehow couldn’t prevent the many bear markets that have visited the U.S. during this considerable period of time. When we discard mark-to-market accounting and attack short-selling practices, aren’t we really just hiding from our problems instead of dealing with them? We tell our kids to face their problems; the same should go for the adults, whether they are in New York or Washington, D.C. Trying to “get shorty” may feel good now, but shooting the messenger doesn’t move us any closer to resolving the problems that lower asset prices bring to light.

— Jack McHugh

U.S. Stocks Gain as Shares of Life Insurers, Centex Lead Rally

Pulte to Buy Centex for $1.3 Billion in Survival Bid

Hartford, Prudential Shares Gain on TARP Speculation

Fed Saw Downside Risks Predominating at March Meeting

SEC Weighs Short-Sale Curbs Amid Lawmaker Pressure