What Goes Wrong When You Blame 'Slimeball' Investors
By Jeff Clark
September 23, 2008
Liquidity is dead.
Last Friday, the "powers that be" in the U.S. government decided to eliminate all risk in the financial markets. Stocks are now a one-way bet. They can only go up. If they start to sell off, then the U.S. Treasury will print enough money to keep the market propped up.
Mortgages are a one-way bet. Housing speculators can borrow 120% of an inflated purchase price without providing any evidence of their ability to make the payments – and just walk away from the deal if home prices turn south. Bankers who provided a stupid loan can transfer the debt to the government, which will simply print enough money to make the banker whole.
Bonds are a one-way bet. You can buy a AAA-rated credit using 30-to-one leverage. If interest rates rise or the bond price falls because of some other adverse condition, you can sell the bond to the U.S. government. It'll just print enough money to pay it off.
It's only a matter of time before the government takes the risk out of playing the lottery. Imagine blowing your entire life savings trying to win the Powerball lottery. If you whine loudly enough, the government might just print enough money to take all those worthless tickets off your hands at face value.
The only folks the government won't bail out are short sellers – those despicable, slimeball individuals who profit as stock prices fall. Short sellers are getting the blame for the toppling economy.
After all, we can't blame the housing speculators who paid too much and took on too much leverage. We can't blame the bankers who loaned money to people who couldn't pay them back. We can't blame the insurance executives who pocketed huge bonuses by juicing up their balance sheets and reporting inflated earnings. And we certainly can't blame the Federal Reserve Board for keeping interest rates artificially low and encouraging rampant speculation in just about every sector of the financial economy.
Nope. The fault lies with the short sellers.
So on Friday, the "powers that be" outlawed short selling of banking stocks.
The stock market rallied. Financial stocks bolted higher. And public investors headed into the weekend feeling all was once again right with the world.
But all is not right.
The government changed the rules in the middle of the game.
Actually, it changed the rules when its team was down by 10 runs in the bottom of the ninth inning. And by doing so, the government murdered liquidity in the stock market.
Let me explain...
Hundreds of thousands of people trade the stock market on a daily basis. These traders provide short-term liquidity, which creates efficient pricing in stocks and options. Because of the liquidity from traders, stocks and options trade in nickel and penny increments.
A lot of traders were hurt last Friday when the government changed the rules. Anyone who was short financial-stock call options was crushed.
And if it can happen in the financial sector, it can happen in the semiconductor, retail, energy, industrial, consumer, and commercial sectors as well as all the rest.
In other words, traders can't trust the stability of the rules. If the umpires change the rules every time your team takes the lead, there really isn't much motivation to play the game.
And that's what happened on Friday.
Disgusted with the instantaneous ban on short selling, traders walked off the field. Liquidity disappeared.
This was most noticeable in the option market. On Thursday, bid/ask spreads were somewhere between $0.01 and $0.05. On Friday, they expanded to over $0.50. For example, you might be able to buy an option for $1.50. But if you tried to turn around and sell it immediately, the best you could get is $1.
You can't succeed trading options if you're underwater as soon as you execute the trade.
Hopefully this will be a temporary condition.
The government banned short selling once before back in 1932 – in the wake of the 1929 stock market crash. Stocks popped a little bit higher on the news. But then the market rolled over and fell to new lows.
Unfortunately, it looks like history is repeating.
Best regards and good trading,
Jeff Clark
