WASHINGTON, June 28, 2012 – Wow, what a crazy day yesterday was on Wall Street. Clearly “they”* knew in advance the essentials of the Supreme Court’s bizarre and too-clever-by-half Obamacare decision, taking a crudely sharpened machete to the averages which began to tank almost from the get-go. Things worsened throughout the day, as all stocks seemed to be getting clobbered, but most particularly medical issues of all kinds including key biotech ETFs that were positively slammed.
When the decision came out—ultimately leaving nearly as many questions unanswered as issues allegedly resolved—things worsened considerably, particularly for those aforementioned biotechs. Making things worse, however, was the increasing conviction that this weekend’s big Euro-meeting would once again decide not to decide, further exacerbating that union’s rapidly deteriorating financial climate.
But then, mirabile dictu**, some hints toward at least a plausible short-term solution to Europe’s ongoing, serial fiscal disasters floated out on the rumor mill. Who knows who planted them so quickly in the investment community? In any event, these broad, positive hints, in spite of Europe’s past track record, were apparently all the algorithmic trading programs needed to liberate the bull once again and party on.
As a result, what ETF Digest’s Dave Fry has termed “the 2:15 Buy Program Express” departed the station nearly on time and at top speed. The Dow, which had been down 200-ish at its worst first sputtered, then roared back to close down a mere 25 or so points.
When a market does that—or its downside opposite for that matter—it’s known as a “reversal.” And when that happens, you can usually expect that same move to play out big time the following morning. And indeed, that should happen in roughly half an hour when they ring the bell at the NYSE. As of just after 9 a.m. EDT, Dow futures are in the green by a whopping 195 points. The S&P 500 is showing an equally impressive positive 24. And the tech-heavy NASDAQ, not to be outdone, is up a near-Herculean 46.5 points. Our friend, Professor Cliché, is standing on his mountaintop right now screaming “Katie, bar the door!”
We’ll see how this plays out today—today being the day before the weekend before the Euros come out with their final communiqué, before the 4th of July holiday-shortened trading week here. Such Fridays are usually low-volume and tepid with a slight to larger bias to the downside. But now, with the algos charged up, their buy programs locked and loaded, we should be massively up today, at least before a possible 2:15 weekend “Sell Program Express.”
But even this may be a poor prognostication. With the market set for such a blowout open, we may also witness a short-squeeze of impressive proportions. Short-squeezes happen when the market experiences a long-term and often very quiet period of time during which large investors, hedge funds, and computerized trading programs short sell the daylights out of stocks they think will be announcing bad news soon. Alternatively, they may be shorting ETFs or baskets of stock either to protect existing portfolios or to take advantage of major market down moves.
For the uninitiated, shorts sell stocks they don’t own at a relatively high price, ride them down (if their prognostications or manipulations are correct), and then buy back those shares (which they’ve borrowed to sell) at a lower price to pocket the different. When I used to teach investment classes, it would take me two or three explanations to get this through the incredulous heads of novice investors who simply couldn’t fathom how you could A.) sell stock you didn’t own, and then B.) buy it back and pocket the difference. After all, how can you make money when your stock is losing money?
It’s simple, really. You can make money both ways. A major portion of old Joe Kennedy’s family fortune was made when the old reprobate ingeniously shorted stocks in and around the beginning of the Great Depression. The market tanked historically during this time, but old Joe was laughing all the way to the bank, as his accounts got richer and richer the more the markets went down because he was usually massively short.
“Well, that must be illegal,” my novice investors used to complain. And to a save and invest sort of person, it certainly does seem like it should be against the law. But it’s not, and this tactic, when properly used, can either hedge investments you don’t want to sell (like the high-dividend utilities and REITs my own portfolio is trying to conserve right now); or be used to profit from major market down moves in general.
Well, let’s end that little lesson right now and get back to today. When large investors or funds have massive short positions that suddenly turn against them, they have almost no choice but to close those positions by buying. For, you see, the stocks that they shorted—the ones they didn’t own—were borrowed, on credit, in “margin” (leveraged) accounts. And, by law, each account has to maintain a certain amount of “equity” (ownership percentage) in the value of their account. When short positions lose lots of that leveraged money, brokerage firms issue “margin calls,” meaning that their short customers, big and small, must either pony up more cash to maintain that equity position (the margin call), or their brokerage firm, by law and by internally set standards, simply starts liquidating their short positions to raise cash (“forced sales” or “forced liquidation).” And, when these short positions are liquidated, the positions are closed out with buy transactions, the reverse of what the average investor usually thinks of as investing.
When this process happens on a massive scale—which usually occurs when plenty of wealthy biggies have made the same bearish bets—this means that massive buying must occur to balance the books. And such massive buying, whether forced or voluntary, is called a short squeeze.
And it looks like we’ll get out the gate in about five minutes with one massive short squeeze, which will cause the market to blast off and free itself from Earth’s atmosphere, at least for an hour or so. Then, as usual, who knows, given this weekend’s events and next week’s holiday? We’re reducing our own short hedges which actually didn’t work very well during the downdraft since they didn’t move very much—something that puzzles us. We’re holding the utilities and ETFs, and may make a few short, opportunistic trading moves.
The NASDAQ looks like it will run away from us this morning, so we won’t chase it. But day traders are likely to have a lot of fun today. On the other hand, conservative investors should probably stay put and not chase. If the market really has turned positive, we’ll know in a few days, and there will still be plenty of time to make some money.
We’ll have other things to say about Obamacare in our other column, Prudent Man. But right now, we’ve got to get into the action that is about to start.
Have a good weekend, and stay prudent.
* “they”: the anonymous rich guys who always get the inside scoop before we do.
** mirabile dictu: a favorite expression of the Roman poet Virgil, literally translated from the Latin as “miraculous to say.”
Disclaimer: The author of this column maintains several active trading and investment portfolios and owns residential and investment real estate.
Positions mentioned above describe this author’s own investment decisions and should not be construed as either buy or sell recommendations. The current market is highly treacherous and all investors travel at their own risk, so caution should be exercised at all times.
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