“naked” short sales

Settling a trade

Every stock market in the world has procedures for how a trade is settled, that is, where and when the buyer brings his cash, the seller his stock and the two complete the bargain entered into when the trade was agreed to.   In the case of the US, this usually occurs three days after the bargain is struck.

Curing a failed trade

Every stock market also has standard procedures to deal with a trade that “fails,” that is, cases where the deal isn’t completed, because one party or the other doesn’t show up or brings the wrong amount of money or the wrong amount of stock.

Penalty fees may be involved.  And, if the seller can’t deliver the stock he has promised to the buyer after a reasonable (but short) amount of time, the broker typically is authorized (and legally required) to buy the agreed-upon shares in the open market, deliver them to the buyer from the original trade, and send a bill to the seller.

“naked” shorts

This brings us to “naked” short sellers.   Before the short seller enters his “sell” order, he is supposed to have good reason to believe he can deliver the required stock on settlement day.   As I mentioned in my first post on short selling, there is an elaborate infrastructure in the US devoted to stock lending, the process of making stocks available for short sellers to borrow.  So the short seller should have a very good idea whether borrowing a given stock is possible or not, and how long it will take to get the stock into his hands.

A short seller who pretty much knows he can’t borrow a given stock, or has no intention of borrowing the stock, but sells it short anyway is called a “naked” short seller. Generally speaking, except for market makers providing temporary liquidity to a market, the practice is illegal. Until the past few years the rules weren’t enforced, so naked shorting occurred anyway.  In the best of circumstances, the buyer ended up being an uncompensated lender to the short seller, who was avoiding posting collateral and paying fees to a stock lender.  At worst, the short seller was trying to manipulate the market in a given stock.

market makers vs. hedge funds

I think it’s important to distinguish here between the activities of market makers in a given stock and those of professional investment managers, like hedge fund operators, who may sell a variety of stocks short.  Both may be “naked” short sellers.  But their activities are very different.

A market maker who sees an imbalance of buyers over sellers in one of his stocks may provide liquidity to the market by shorting shares to buyers.  His intention is to buy the shares back quickly himself to reestablish a neutral position, not to borrow the stock from a third party (and pay fees).  Clearly, the market maker intends to make money from his shorting activity, but one can reasonably argue that his actions have a stabilizing function.

This is very different, I think, from the actions of a professional investment manager, who from the outset doesn’t intend to honor the bargain he makes with a buyer.  He depends instead on the rules against naked shorting not being enforced so that he can evade his contractual obligation for as long as possible.

His actions are basically destabilizing, since he is overriding one of the basic safety features of any market that allows short selling–the requirement that you can only sell stock you have an ownership right to.

Why is this distinction important?–because advocates of naked shorting seem to me to deliberately muddy the waters by citing the benefits of shorting by market makers as a defense for the destabilizing actions of some professional money managers.

What’s wrong with naked shorting, in my opinion

1.  The regulatory requirement that a short seller be able to settle his trades is a reasonable one.

–It ensures that the buyer is able to profit if his “buy” decision is correct, instead of winding up with a failed trade and a stock that has run away from him.

–It also eliminates the possibility of bogus transactions by short sellers who can’t borrow stock, or who don’t want to post collateral or pay fees, yet who want to defend their short positions by impeding the upward movement of the stock.

2.  The need to borrow shares sets a natural limit (the number of shares outstanding) on how how many shares of a company’s stock can be shorted.  In practice, the limit to shorting is actually lower–the number of shares that holders are willing to lend.  The ability to create phantom shares through naked shorting tilts the playing field sharply in favor of short sellers.

3.  From a tactical point of view, holders of a stock have two defenses against short sellers, both of which are neutralized by naked shorting.  They are:

–Owners can call back the stock their organizations have lent to short sellers, forcing the latter either to find shares to borrow elsewhere or go into the market and “cover” (buy back the stock) their short positions.  Or,

–holders themselves can enter the market as buyers and try to support the current price by absorbing all the stock for sale, and potentially drive the price higher.

Either tactic can create a “short squeeze,” that is, a self-perpetuating scramble of short sellers to cover their short positions that, like a snowball rolling downhill, pushed the stock price considerably higher.  However, naked shorting removes these risk elements for short sellers.

You can’t call back stock that has never been lent and exists only in the imaginations of the short seller and his broker.  You also can’t dry up  the pool of sellers if they can “manufacture” new stock to short out of thin air.

A problem until 2005

That’s when the SEC instituted Regulation SHO, which makes brokers to follow rules that were already on the books.  In particular, it requires brokers to:

–document that borrowed stock is available to settle a trade before the bargain is struck, and

–“close out” a trade that has failed for 13 consecutive trading days by buying in the securities and delivering them to the original buyer.  The close out rule only applies, however, to stocks that exceed specified levels of failed trades.

In the link to the SEC website above, the agency is at great pains to point out that it does not regulate “pink sheet” stocks, seemingly implying that naked shorting is common there, even today.

There’s also academic research demonstrating that manipulative naked shorting was prevalent until Regulation SHO, after which it has substantially disappeared.  Oddly enough, I first became aware of this paper by reading commentary in Barron’s that made fun of SEC concern about naked shorting of Bear Stearns and Lehman (the paper concludes there wasn’t any–thanks to Regulation SHO).

Why is this important now?

The SEC is reviewing its short selling regulations.  It has just reinstated a modified uptick rule and proposes looking at naked shorting next.  There’s bound to be brokerage industry argument that Regulation SHO isn’t needed because naked shorting wasn’t a factor in the collapse of financial stocks in 2008.  But that’s just not true.

Short-selling and the uptick rule

The SEC has been holding hearings about reinstating the “uptick rule” for short-selling in the US market, and has come up with a new rule.  The rule-making comes as a reaction to assertions that the Wall Street decline in late 2008 was made worse by speculative short sellers taking advantage of the removal of the uptick rule in 2007.  What are the issues?


A short seller borrows stock from an owner, promising to return it on demand, and  promptly sells it.  The debt to the owner is expressed, not in dollars, but in a specific number of shares of a certain stock.  So at some point, the short seller must buy the stock back in the market and return it.  This can happen because the short seller decides his investment idea has outlived its usefulness, or because the original owner “calls” the stock back to him.

why sell short?

The short seller may think the stock in question will go down, so that he can make money by buying it back at a lower price and then returning it to the original owner.

Or he may have a hedging strategy in mind (this was the original “hedge fund” idea).  If so, he will reinvest the sale proceeds in something else he thinks will do better than the stock he sold short.  He might, for example, short Toyota and go long (i.e., buy) Ford.  In this case, he will make money if Ford goes up more, or down less, than Toyota.  He doesn’t need the stock he’s betting against to be an absolute loser, just a relative one.

Short selling is highly institutionalized on Wall Street.  Many financial firms and most large institutional investors have stock lending departments, which deal with each other to facilitate short selling by locating and arranging for stock to be borrowed and arranging for collateral to be provided.  (As a portfolio manager, I understood why my firm would do stock lending.  It didn’t thrill me, though.  It always irked me on those occasions when, despite their promises to the contrary, the borrower refused to return a stock I wanted to sell.)

Then, of course, there was the incredible disaster at AIG–and apparently other middlemen as well–where that company took the collateral it was holding, typically Treasury bonds, sold it and replaced it with sub-prime mortgage securities so it could earn higher interest income.  After sub-prime mortgage securities tanked, short sellers couldn’t close out their positions because AIG couldn’t give them back their collateral.  AIG needed another $40 billion+ from the government to clean up this mess.  But that’s another story.

the uptick rule

The uptick rule was instituted for exchange-traded stocks by the SEC in 1938, in response to a market swoon in 1937.  The SEC believed the market’s fall was caused, or at least made considerably worse, by rampant speculative short selling.  In response to brokerage industry lobbying, the rule was rescinded in July 2007–just at the beginning of a sharp market contraction made considerably worse, in the view of many, by rampant speculative short selling.

The rule was that you could only sell a stock short on an uptick.  That is to say, you could only sell a stock short either:

–at a price higher than the immediately previous trade, or

–at the same price as the previous trade, if the last price that was different from the previous trade was a lower price.

Put in less precise terms, the rule says that if a stock is declining you can’t hold it down or push the price even lower  by selling it short.  You can only sell short into a rebound (and thereby prevent that rebound from advancing), but if the stock turns lower again, you have to stop selling it short.

Remember, none of this prevents a “natural” seller (someone who owns the stock) from selling.  The uptick rule only applies to short sellers.

the new rule

The SEC has just instituted a new, limited anti-short selling rule.  It applies only to stocks which have fallen by 10% in price during a trading day, and applies only to the remainder of that trading day and the following trading day.

During that time, a stock may only be sold short if the sale price is higher than the highest bid price maintained by any market maker in the stock.  In other words, the short sale trade has to establish an uptick.

The main untested feature of the new rule is that it only kicks in after a stock has fallen by 10%  Before that, it’s a free-for-all.  It may well happen that market makers decide to move the market in a stock that’s being sold short down as fast as possible to the 10% mark, where they receive temporary protection against short sellers.  In my experience, that’s what happens in foreign markets when market makers encounter any sort of concerted selling.

“naked” shorts are much more important, I think

I don’t find anything particularly wrong with short selling–I should mention, though, that I worked on, and later ran, a (very successful) short portfolio in the early Eighties.  I’m also not sure that the uptick rule is a significant issue.

If anything, there may be unintended negative consequences.  My experience outside the US with markets that put arbitrary, or commodity market-like, restrictions on selling is that they end up with declines that are longer in time and deeper in extent than similar markets that don’t have such restrictions.

I think that colorfully named “naked” shorts are a much more significant concern.  More on that topic in my next post.

Consumer confidence: stock market implications

The Conference Board Consumer Confidence Index

The Conference Board, a private economic analysis company, released the latest figures for its Consumer Confidence Index on February 23.  They showed a sharp, and unexpected, drop in consumer sentiment.  What does this mean?

How it’s calculated

The Conference Board hires an outside surveying firm to poll 5,000 families each month.  They answer five questions concerning their assessment of:  job prospects today, job prospects in six months, overall economic activity today, activity in six months, and the family’s income in six months.  The answers can only be:  positive, neural or negative.

The Conference Board throws out the “neutrals” and calculates the percentage of positives in the group of positives + negatives (for what it’s worth, this is called a diffusion index). It then compares its results with those of a base year, 1985, to come up with the final result.

The Board also produces two sub-indices, the Present Situation and Expectations Index.

What the interviewees said

They’re the most pessimistic they’ve been since 1983 about the current situation.  It only took a few respondents swinging from positive to negative to achieve this result (where have they been the past three years?).  And I think that historically the Present Situation index has had less predictive value than the Expectations Index.

Expectations about what the economy will look like in mid-summer have also deteriorated, however, after months of steady improvement.  And the numbers of respondents shifting from optimism to pessimism is considerably larger.

How Wall Street uses this information

Economists argue that there’s a direct relationship between consumers’ confidence and their spending behavior.  A dip in consumer expectations about the path of economic recovery, therefore, may be signaling that retail spending is about to fall off.

There’s some question, though, as to whether sentiment indicators give much insight into future economic activity or are simply reflective of conditions as they are today.  Certainly, other survey information like business confidence, employment trends or overall leading economic indicators are all continuing to tell a more positive story.  In addition, publicly-listed consumer companies have by and large been saying that the economy is past the worst and business is picking up.

Can Wall Street be good if consumer confidence is bad?

No, if confidence remains depressed for, say, another year.  But there are several factors that argue the stock market can do well, despite poor consumer confidence numbers.

–this is the worst economy for the US in the past seventy years, and one of the longest recessions, so it would be surprising if consumers weren’t feeling bad.  Remember, too, that the previous low point was in 1983, an economic recovery year.  So confidence can act at times as a lagging indicator.

–in the textbooks, economic recoveries start by low interest rates stimulating industrial production.  That spending results in companies hiring new workers, sparking consumer spending as the second leg of the upturn.  In past recessions in the US, however, this order has been reversed.  Consumer spending has come first, triggering hiring and then industrial expansion.  But this time around, the banking crisis has destroyed the housing industry, a key engine in consumer spending revival.  So, I think, we’re going to have a “textbook” recovery.  This means new hiring will come later than normal in the cycle.  Peoples’ expectations are being disappointed–but maybe only for six months.

–I think that for years to come there will be a higher level of structural unemployment in the US than we are used to.  Though not really hard evidence, a recent story in the New York Times about “The New Poor” illustrates what I mean.  The problem of older, less skilled, computer-illiterate workers has been with us for a decade or more, but has been disguised by the artificial economic vigor induced by the housing boom.  This is a national tragedy.  And the negative responses to consumer sentiment surveys from the long-term unemployed and their relatives and neighbors will likely depress consumer confidence indices for a long time to come.

Taking off my hat as a human being and putting on my hat as an investor, however, it seems to me that this 5% or so of the population will have very little effect on the profits of publicly-traded companies that cater to US customers. (For example, look at my post on an FDIC study showing that 25% of US households, most of them less affluent, are outside the mainstream banking system.) Revenue growth may be a little slower, but profit growth may not be affected at all.

–Looking at the composition of the S&P 500, half the revenue comes from outside the US.  The consumer discretionary sector, where the brunt of the falloff in spending will likely be felt, comprises about 11% of the index.  Let’s say that this group gets all its revenue from US customers (the high end has lots of foreign revenue, though).  If we assume it loses 5% of its customers (which is too high) that comprise 2% of its revenue (again too high), profits may be 2%-4% less than they would be otherwise.  The effect on the S&P as a whole?  –a loss of .20%-.45% to the index growth rate.

Again, I don’t mean to minimize the social and political cost of having a permanent underclass of older unemployed citizens.  But the numbers alone seem to argue that the S&P will be relatively unaffected.

Looking at inventory (II): figuring operating leverage

Analysts get information from company financials by comparing two or more sets

Even if a company’s financial statements have an almost photographic fidelity to the structure and inner workings of the enterprise they represent, it’s very difficult for the outside observer to understand what is being portrayed from one set of financials alone–unless, of course, the company is in disastrous financial shape.

Instead, the analyst gets his information from comparison of two or more sets of financials, preferably covering relatively short periods of time, with one another.  In many ways, sequential quarters are the best, since there is the smallest lapse of time between the observation points.  For companies with significant seasonality in their product mix, however, comparison of year over year quarters will produce the fewest distortions.

Question #1:  is there leverage?

One of the first and most basic question you should ask yourself about a company you are starting to look at is whether it has either financial or operating leverage.  A company with leverage is one where a change in revenue produces disproportionately large changes in operating income.  Leverage comes in two types:

Financial leverage comes from a company’s capital structure.  The idea is that a company that uses debt to finance expansion will produce higher returns on equity as long as the operating profits produced by expansion are higher than the interest expense on the borrowings.

You can do the calculations yourself, but publications like Value Line have statistical arrays that do the work for you.  Look at the lines for “Return on Capital” and “Return on Equity.”  If the numbers are different, the company has financial leverage.  Hopefully the returns on equity are higher than the returns on capital (debt + equity).  That’s the way it’s supposed to work.

Operating leverage, which comes from the operating structure of the company.  Firms with operating leverage typically have high fixed expenses of maintaining a manufacturing (or service) operation, but low variable costs of making each unit sold.

FIFO companies

For a company that uses FIFO accounting (see the first post in this series), finding out the operating profit on an incremental unit of production is easy.

1.  Take the revenue figure for the more recent of the quarter you’re comparing and subtract from it the revenue for the more distant quarter in time.  That gives you incremental revenue.

2.  Do the same for the two operating income figures.  That gives you incremental income.

3.  Divide incremental income by incremental revenue and you get an incremental margin.

4.  Compare this figure with the operating margin for either of the two comparison quarters.  If the incremental margin is larger than the average margin for the quarters, the firm in question has operating leverage.  And, if so, you know that in forecasting future quarters, incremental revenue will earn the incremental profit margin.  Therefore, even small increases in revenue can produce positive earnings surprises.  Conversely, even small revenue shortfalls can produce earnigs disappointments.

LIFO companies

For a company that uses LIFO, however, the situation isn’t as straightforward.  Under LIFO accounting, every quarter after the first can be a kind of mid-course correction to the estimates the company employed in arriving at first-quarter cost of goods.

I think it’s reasonable to assume that a company uses a consistent estimating methodology from one year to the next.  If the company chose last year to add in a little safety margin for earnings later in the year by making a high initial estimate for cost of goods, then it’s a good bet that they’ll do the same for this year.

Therefore, it’s a pretty safe assumption that we can analyze incremental margins using the first quarters of two consecutive years.  In any event, it’s the best we can do.

On the other hand, we take a real risk if we use second through fourth quarters by themselves in a year on year comparison.  We can’t rule out the possibility that they’re just residuals left from the re-estimating process.  But we can use (Q1 + Q2) of the current year vs (Q1 + Q2) of last year to do the incremental calculation described in the FIFO section above.  Similarly, we can use Q1 + Q2 + Q3 or the full year as our comparison base.

For the same reason we should hesitate to  use Q2, Q3 or Q4 alone, we also probably shouldn’t use sequential quarters to do the calculation.

For a professional securities analyst, it may make sense to do quarterly year on year or sequential comparisons for a LIFO company anyway.  If you look at enough years, you may find that there’s a consistent pattern to the LIFO adjustments, so you can anticipate with the company is likely to do in the coming quarters.  Even if there isn’t, you may learn enough to make this a topic of conversation with the company’s management.  If someone is willing to take the time to explain how they approach LIFO estimates, you’ll doubtless learn a lot of things from the explanation that you’d never have thought about otherwise.