On February 24th, 2010 there was an article in Reuters that stated that the Securities Exchange Commission had voted 3 to 2 on a rule designed to help “boost” investor confidence by putting a roadblock in front of short sellers. “Under the SEC’s rule, if a stock falls more than ten percent in a day, curbs will kick in, allowing short selling only above the national best bid.” Short sellers are often characterized, as seedy, back alley, lowlifes who are hell bent trying to bring down our country by sucking the capital out of perfectly fine companies. There are many investors/traders in the markets that believe shorting a stock is flat out “Un-American.” For those reading who feel this way, I would encourage you to pick up a copy of James Surowiecki’s “The Wisdom of Crowds.” In the book Mr. Surowiecki makes a compelling argument that the problem with the stock market is not that there are short sellers, but actually just the opposite. We need more short sellers. Sounds like blasphemy you say?

The stock market is a place where a large group of people try to determine the “fair” value of a stock. The buying and selling of the equities should be enough to create equilibrium at a specific price point, and therefore define what that “fair” price should be. The only problem with this idea is that it requires that all stock market participants be investors – not traders.

Stock traders are in it to win it. They are speculators who are really not concerned with the “fair” value of a stock. They are more interested in the “Greater Fool Theory.” The theory goes this way: I will buy this stock, not because I believe in the Book Value, or the EPS, or the pride of being part owner of a growing company, but instead because I believe that there is a “Greater Fool” out there that will be willing to buy the stock from me at a higher price than what I paid.” Investors are typically slow to move as they buy and sell their investments and can sometimes be the beneficiaries of trader’s bullish sentiment. On the other hand they can just as quickly become their victims. This is why short sellers are so important to the market.  Short traders balance out the bullish speculators. Without these short sellers we can all become victims of the dreaded bubble.

Most would agree that market bubbles are caused by ramped speculation (Irrational Exuberance). The problem with bubbles is that they pop and when they do, life savings can be devastated. Let’s dive into the pensive (Harry Potter terms for a stroll down memory lane) and take a look at POT (pre split prices). In 2006 Potash Corp was valued at approximately $37.00 per share. Bullish speculators believed that based on the projected growth in China, Potash would be in great demand. Over the next seventeen months POT soared to $233.00 per share.  That is a 530% ROI. Sometime in 2006 all of the speculators left POT and its value fell to a low of approximately $47.00. Investors that held on through the decline were left with a return of just 27% at the low. The only problem that an investor would have with a 27% return is that they no longer have a 530% return. If the investor held on to the current day and current price levels their return would be around 190%. Not bad but not 530%.
 


What happened to cause the POT bubble - unrestrained bullish speculation! Who protects the public against unrestrained bullish speculation - Short Sellers! Short sellers help to slow the pace of bullish trends. By definition, a bullish trend is a series of higher highs and higher lows. If you take a peek at a monthly chart of POT there are no higher lows, no pullbacks. This is how bubbles are formed - higher highs with no higher lows. The higher a stock, or the market for that matter, goes without a downturn, the worse it will be when it happens. You know, the bigger they are the harder they fall.

Another more recent example is GMCR. Rampant speculation over coffee in individual containers – What a country! Again in the chart below you can see that there were no periods of sell during its parabolic move higher. All I am saying is that a move like this without retracements on the way up is eventually doomed.
 


Oh… by the way. Have you seen the AAPL chart recently? I’m just sayin’…



The Wizard’s daily signals called APPL short on April 16th, 2012. The first target is $404.17 – Ouch!
 



So here is the moral of the story. We need a healthy group of short sellers in the market to offset the bullish speculators. Without them we will always be susceptible to not just market corrections, but market crashes. Find a short seller today and give them a hug!

Happy Trading –
Chris Irvin
The Wizard

Disclosure: No Position in any securities mentioned.

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