Tuesday, October 28, 2008
What Happened Today
The Dow went up an unthinkable 900 points today, almost 11%.
What happened today was apparently a market-wide "short squeeze". Here's how it works: When you are confident the market is going down, you borrow shares from your broker, then sell them. On an agreed-upon date you go into the market and buy the same number of shares and return them to your broker. If the shares went down, the difference between what you got for the shares you borrowed and what it cost you to replace them, is your profit. That is called a short sale. The arrangement with your broker is a short sale contract.
[The broker doesn't care that you are doing this. He gets a commission when he buys the shares to lend to you. He gets a commission when you buy the shares to return to him. He gets a commission when he sells them back to the market. He gets a commission for setting up the short sale contract. You are betting against the market, not against your broker.]
Consider what happens if you guess wrong and the stock starts going up instead. You want to buy stock to return to your broker as soon as you can before it goes up more and costs you even more to buy the stock you need. You have to buy right away to limit your losses. That is called covering a short sale. If lots of other short sellers are forced to buy at the same time for the same reason, the sudden buying pressure forces the stock's price to shoot up suddenly. That is called a "short squeeze" in that stock.
Now consider a plummeting stock market such as we have had this past month. It has been a near-certainty that any stock you borrow and sell will be lower by the time you have to return it. There have to have been tons of short sales contracts bought and sold and tons of money made on them. The more the market fell and and the more certain it became that it would fall further, the more the short sales contracts multiplied, and on virtually every stock.
I should add that no one leaves matters to chance. The signal to buy to cut losses is set to go off automatically at a price selected by the short seller when he starts the contract. That is called program buying.
Today there was an upward blip because of the expectation the Federal Reserve would lower interest rates. It started to trigger buy orders to cover short sales contracts. The increased buying forced prices up, which triggered still more buy-to-cover orders, which forced the market up still more, until it became a chain reaction.
The SEC has rules limiting program selling which can drive individual stocks or the whole market down ruinously and provoke a selling panic and a crash [which is what happened in 1929]. Apparently there are no SEC rules limiting program buying, because the market going up is generally considered to be a good thing. And everybody loves seeing bears (AKA 'vultures') getting their asses kicked in the market.
Anyway, apparently that is what happened today. There was a market-wide short squeeze.
While it is wonderful news that so many speculators lost so much money today, it also means the run-up does not reflect any fundamental recovery in the market. It was just another episode of speculators manipulating, and occasionally being manipulated by, the market.