Short-sale Ban Is No Panacea

09/22/08 9:05 AM EST

Good Monday morning...We begin the day with volatile trading in the pre-market futures this morning, as they have rallied from their early-morning lows.  Currently the S&P 500 futures have rallied more than 20 points, Dow futures 200 points and Nasdaq 100 futures a whopping 40 points (nearly 2.5%) from their morning lows (helped along by a stock buyback announcement from Microsoft, and a just-released one from Hewlett-Packard).

Last week was obviously historic, and no doubt we're all a bit frazzled by the price moves and a weekend full of analysis and opinion.  The steps taken last week, and which continue to unfold this morning, have profound repercussions and a single weekend is not enough time to sort through them all.

The volatility we saw over the past week has been rarely matched in modern history.  If we extrapolate the daily moves from last week, it would suggest the S&P 500 would move nearly 80% one way or the other over the course of the next year.  In the past 70 years, that has been exceeded only once, in the aftermath of the '87 crash (when it reached an astounding 240%).

Prior to that, we saw several periods where volatility was as high or higher than what we've seen now.  Almost all of it was concentrated in the 1930's.  Coincidence or not, that was also when we saw some of the heaviest intervention by government in the free markets.

One discussion making the rounds is of another time when regulators decided to ban the short sale of stock, in 1932.  Below I've included the headlines (via The New York Times) on several dates leading up to February 19th, when it was announced.  Some of the hyperbole is eerily similar to what we've seen recently.

Be sure to look at the red dot on the included chart, which shows the date of the announcement and stocks' performance fore and aft.

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Feb 15, 1932

COMPTON ATTACKS 'FALSE' SHORT SALES

Deals for Next Day's Delivery Are Unfair.

Feb 18

CALLS 'BEARS' PERIL TO RECONSTRUCTION

W.R. Perkins Tells Senators Gravest Menace to Congress's Steps Lies in Short Selling.

CHARGE HIRED PROPAGANDA

Rumors, True or False, Are Spread, He Says -- Dr. S.S. Huebner Defends 'Stabilizing' Practice.

Feb 19

NEW EXCHANGE RULE PUTS DRASTIC CURB UPON SHORT SELLING

After April 1 Brokers Must Obtain Written Consent From Clients to Lend Stock.

END OF BIG BEARS IS SEEN

Market Rallies on Advance Rumors -- Orders Sent to Coast After Close Here.

BAN HAILED IN CAPITAL

But Members of Congress Disagree on Whether It Will Head Off Legislation.

NEW EXCHANGE RULE CURBS SHORT SALES

In the most drastic reform introduced since the country-wide controversy over short selling began, the New York Stock Exchange announced yesterday that, beginning April 1, its member firms would be required tc obtain the express consent of customers before their stock could be lent to protect commitments on the down side of the market.

Feb 19

ACTION BY EXCHANGE GOOD, SENATORS SAY

 But Disagree on Whether Curb on Short Sales Will Head Off Legislation.

SOME FOR CONGRESS BAN

Capper Believes Restrictions on Bears Were Prompted by Fear of Inquiry.

Feb 20

HOOVER REVEALS HE DEMANDED CURB ON SHORT SELLING

President Warned Exchange Heads They Must Adequately Protect Investors.

SEES RECOVERY RETARDED

Legislation With Administration Backing Is Hinted if Regulation Here Fails.

ACTION IN SENATE URGED Report on Regulatory Bills Is Asked -- House Hearing Evokes Diverse Views.  President Hoover in a statement today condemned short selling for speculative profit on the New York Stock Exchange and said that he and other administration officials had frequently expressed the view to managers of the Exchange that measures should be taken to protect investors from "artificial depression" of the prices of securities they hold.

March 21

To the Editor of The New York Times: Short sales of stock are an almost unmitigated evil, and if Congress can devise means to limit or perhaps eliminate the practice altogether, it will have taken a long step forward in preventing such disaster as almost overwhelmed that portion of the public which endeavors to save and invest some portion of its income and for a time threatened to overturn our entire financial system last December.

April 10

GET DATA FOR SENATORS

Brokers Comply With Exchange Request for Full Reports on All Short Sales.

With stocks rallying moderately as uneasy speculators covered their short commitments, the New York Stock Exchange proceeded yesterday with feverish haste to assemble the vast amount of statistical evidence which Richard Whitney, its president, has been directed to produce at the opening tomorrow in Washington of the Senate Banking and Currency Committee's market investigation.

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A more recent piece of historical prospective is from Pakistan in June:

Kevin Depew at Minyanville pointed out a chart of the Pakistani benchmark equity index with a highlight showing the ban on short sales:

The index rose about 15% over a few days' time before rolling over and losing nearly 30% since.

While the circumstances surrounding the ban on short sales was different, China also instituted a similar policy a couple of years ago.  The benchmark indices there continued to drop for around a month before a low was established.

The chain of events from the 1930's in our domestic market isn't all that different from what we've seen now, though on a much greater scale.  We got a major market decline, an attempt to manipulate the market by government, displays of public anger over Wall Street machinations, and then the tedium of actually complying with the rules.  And no doubt, a bevy of lawsuits by those hurt by the developments.

As you can see from the chart, the market was already in trouble prior to the short sale ban.  Right before it was announced, the Dow jumped 20% over a course of a couple of days...and then proceeded to slump another 50% during the next five months before the ultimate low was cemented.

I don't think we're in for anything like the episode in the 1930's, or even Pakistan's latest failure.  But it's important to have some context for these manipulations, and understand that they rarely work as advertised, at least after the initial short-term pop.  We've clearly seen a pattern of "shoot first, ask questions later", which perhaps was necessary to stave off a crash last week, and now we're getting the backpedaling we always get as the implementation isn't nearly as easy as the press release.

Now that the glare of analysis has been shone on these measures, some will make it into policy, some won't, and there will be lawsuits tying up the rest for months on end.  The reality rarely justifies the initial wave of relief and enthusiasm, which is why we so often see markets slump back after extreme pops like last week.  It happened in 1932, it happened in 1987, and it's probably going to happen now.

When we look at the events of last week, we did get many of the usual pieces that highlight inflection points:

*  Record-high volume

*  A sustained and extreme number of stocks trading at new lows

*  Panic conditions (as evidenced by the Panic Button)

*  Reversal patterns from a new low

*  A decades-long new high in historical volatility

We didn't see an overwhelming number of our equity-based sentiment indicators reach extreme territory, but this was not primarily an equity-market panic.  It was concentrated in the credit markets, which is why we focused so much on the Panic Button indicator of credit market stress last week.

Now that that has passed, and likely won't be exceeded, perhaps we will get another equity-market decline that finally triggers more extremes there.  I don't think it's necessary, but it's certainly possible.  Even probable.

Looking at historical precedents for what we saw last week in terms of government intervention and market behavior, the most likely scenario continues to appear to be an approximately one- to three-week decline from last week's euphoric ending as the realities of what hit us begin to percolate.  From there, we should have a better risk/reward opportunity for intermediate-term longs, and I'm still looking for decent gains during the fourth quarter.

As for the very short-term, we may have more upside to go as traders sort out last week's short sale ban and what it could mean, and we get the reaction from corporate announcements like we saw this morning from MSFT and HPQ.  But I don't think we're in for a "V" bottom, and will ultimately test Thursday's low - maybe not to the point, but it would be extremely rare to not see some sort of backing off from last week's gains.  If we see the S&P push into the 1280 - 1300 area early this week, I would be more inclined to sell it short than try to buy into it.