At the Heart of This Rally, Shorts Were Busy Buying
A lot of people had come to believe that short selling was like printing money. But Thursday, the shorts’ smug attitude was cut to ribbons, as stocks staged a surprise rally that fed on the shorts’ worst fear: the bear market’s end.
The shorts--traders who borrow stock and sell it, expecting to buy it back cheaper later--have ruled the market’s slide since July. Shares sold short on the New York Stock Exchange hit a record 706.3 million in September.
As the shorts sell, they help drive the market down. In a bear market that already has enough to worry about, the shorts make things worse.
But in the market’s usual perverse way of doing things, a growing short position also becomes a weapon against the very traders who use that tactic: At the first sign of a real rally, terrified shorts often buy like crazy to cover their positions.
As the shorts start buying, the action attracts more buyers, and the rally feeds on itself. The more shorts in the market, the greater the potential fuel for panic rallies. And with so many more amateur traders shorting these days, trigger fingers are the rule rather than the exception.
Thursday’s 64.85-point surge in the Dow Jones industrials, to 2,452.72, led a broad market rally that was to a great degree driven by short-covering, many traders said:
* “I think that was basically it,” said Tracy Wheeler, over-the-counter trading chief at Seidler Amdec Securities in Los Angeles. “The shorts figure they better buy now,” he said, because of the possibility of imminent deals in federal budget talks and in the Iraq-Kuwait crisis.
* Robert O’Toole, head of OTC institutional trading for Shearson Lehman in New York, agreed that much of the buying was by shorts, rather than by true investors hunting for bargains. Quickly surveying traders around his desk, he said, “We don’t see the major institutions buying today.”
Other traders, however, insisted there was legitimate buying throughout the day, as optimistic investors began to look past the budget and Mideast crises. “I think the last half of the action was certainly short-covering,” said Sid Dorr, institutional trader at Charles Schwab & Co. in San Francisco. “But I also think that as much as the market has come down, it has exposed a lot of values in stocks,” and that investors were responding to that Thursday, he said.
Some technical analysts, who watch market chart patterns, also argue that Wall Street is primed for a sustainable rally. Andrew Addison, who writes the Addison Report market newsletter from Franklin, Mass., notes that while about 700 NYSE stocks hit new lows in the deep market selloff in late August, the number of new lows at the depths of last week’s selloff was around 400.
That says the market’s internals are strengthening, he contends. He thinks the Dow could rise about 8%, to 2,650, by year’s end.
The huge short position suggests we could get there even faster. The new short players are likely to lose sleep over the prospects of big losses if stocks turn up. So more who didn’t cover their positions Thursday may do so today. Good news from Washington or the Mideast would cause the shorts further indigestion.
To many analysts, the bear market still is on. But the rallies that will occur periodically within the bear cycle now seem likely to be wild affairs, given the unprecedented short presence.
New Trouble for OTC Stocks: More brokerages are cutting back on market making in over-the-counter stocks. That will make it even harder to trade these mostly smaller issues.
Pacific Brokerage Services, a Los Angeles-based discount broker, last week halted market-making activities entirely--meaning it will no longer keep inventories of specific stocks, and so will no longer stand ready to buy or sell those issues at set prices. The firm had kept markets in more than 40 OTC stocks, such as software firm Borland International and computer systems firm MIPS Computer.
Steven Wallace, Pacific’s owner, denied rumors that the firm was in financial trouble. “Far from it. We were profitable in September,” despite the bear market, he said. The desire to stay profitable was what forced his hand, Wallace said. “The OTC market is very volatile, and the risk-reward ratio (in market making) isn’t worth it,” he said.
Likewise, Wedbush Morgan Securities in Los Angeles has trimmed its OTC market-making positions by 5% to 7% in the past 30 days, to about 350 stocks, said Larry Rice, OTC trading chief.
When an OTC stock is dropped by a market maker, there is one fewer firm price quote available. In many cases, only a few brokerages may be left quoting firm prices--which makes it harder for investors to buy or sell the stock, and often tougher to get a decent price.
Many market makers have been getting killed by maintaining inventories in small OTC stocks that have collapsed in recent months. The market makers are obligated to use their capital to buy the shares as investors dump them. Yet there are no buyers on the other side.
What’s more, Wallace and other small brokerage chiefs complain that many larger trading houses refuse to deal in OTC stocks when the market is free-falling. “When the market is down 100 points, there still are firms that don’t answer their phones,” he contends.
Nationwide, the National Assn. of Securities Dealers says the number of market-maker positions in individual OTC stocks totaled 45,496 in September, down from 47,667 in July. Clearly, more brokers will drop out as the bear drags on. That’s going to be a growing problem for investors, and for the companies behind the stocks.
