Rate Hikes To End
Earlier in the year, (see both the March 28th andJune 20th issues), we forecast that the Fed was likely to soon end its measured pace ofrate increases. Despite the devastation of Katrina, which alone should prompt Fedhesitation, catalysts for careful consideration were already in hand. The constantrise in price of oil, now close to triple the four-year average from 2000-2003 and thealmost certain appearance of a delayed reaction for the economy after ten rate hikes,placing interest rates at the exact same level as four years ago, just before 911. Walmart's revelation (pre-Katrina) that consumers were less enthusiastic about travelingin their autos to stores to spend hard earned cash should have raised eyebrows, since thegiant chain is the nation's largest. Over the last 12 months, Walmart's revenueswere more than $300 billion, a sum equivalent to 2.5% of the nation's GDP. How hugeis Walmart? They have more employees than the city of Philadelphia, the nation'sfifth largest. Could rate hikes continue? No! Although the Fed hasclearly indicated a need to slow down the rise in housing prices, attempting to accomplishthe task by raising interest rates is problematic. Yes, speculation in those marketsthat have already gone nuts will likely slow or cease, but at the same time, rateincreases are nationwide and not locale specific; and the effect will be to penalizeinstead, those millions of consumers who do not live in "bubble" locales andwill tend to brake consumer spending, perhaps significantly. While Fed Funds futurescontracts still indicate more rate hikes are possible we believe there will be none forthe foreseeable future.
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Battle Lines Have Been Drawn
The NYSE reported that short interest up to August 15th rose 2.7%to yet another new record of 8.59 billion shares and the days-to-cover ratio rose from 5.8to 6. For years, as one record fell and another was established, most commentary hascentered on a bullish interpretation as shorted shares must eventually be covered. However, there is also a case to be made that sophistication is required of most shortsellers and that a larger short interest means those sophisticates are looking for lowerstock prices. However, given that the expansion in short interest has proceededthrough bull and bear markets, it is clear to this writer that the numbers are irrelevantas a forecasting tool and only point to the circumstance which we have argued vehementlyfor many months; that shorts need not cover positions that have fallen dramatically inprice. As those positions remain uncovered and new positions are established, moreshares are reported short. As previously explained in our newsletter, the marginrequired for short sales contracts along with the price and eventually, shorts may be ableto pull out almost all of their stake and all of the assumed profit. In fact, thecontinued expansion of the short interest statistics is proof of our assumption. Unfortunately, the downside is also proof that shareholders have suffered and thegovernment does not receive its due in capital gains taxes. In addition, we believethat systemic problems are much worse than anyone can imagine.
Bear in mind that derivatives such as options and single stockfutures allow market makers to hedge risks by shorting stocks. Case-in-point:investor A wishes to protect against a decline in stock ABC and buys put options; trader Bhas three alternatives, he may sell the put to Investor A and assume all the downsiderisk, or hedge by buying cheaper out-of-the-money puts, or hedge by shorting the stockitself. Market makers receive a limited exemption from standard deliveryrequirements thus enabling failure-to-delivery problems for certain issues to balloon wayout of control.
Despite the implementation of Reg. SHO, the SEC remainsfundamentally ignorant of the ongoing problems caused by failures-to-deliver of shortedstock. While allowing limited exemptions to market makers and others for the purposeof maintaining orderly and liquid markets, failures have expanded dramatically over thecourse of time and represent a real threat to certain companies as the equivalent ofcounterfeit shares dilute value to legitimate owners. How can counterfeit sharesexist? Assume Investor A is long XYZ on margin. The broker has the right tolend A's shares to speculator B to sell short. Investor C is on the buy side of thattransaction and sees his shares hit his brokerage account. The entry is electronicand now both A and C see the shares on their brokerage statement, in essence, two ownersof the same shares. Anne Nazareth, Director of Market Regulation at the SEC is onrecord in favor of eliminating paper certificates entirely and forcing all shareholderstotally into the electronic bookkeeping system already in use. Heaven forfend! Regulation SHO has provided all the evidence we need to clearly see ongoing abuse. Case in point: Overstock.com (see our recent commentary atwww.cross-currents.net/caveat.pdf). OSTK has become the poster child of thequintessential "naked short." Recently, OSTK CEO Dr. Patrick Byrne offeredample evidence that the available "float" of OSTK stock may have now contractedto fewer than 300,000 shares. So then, how do 6.55 million shares remainshorted?! As we showed in a special report last December(www.cross-currents.net/stutz.pdf), the same circumstance that permitted the greatestshort squeeze of all time was that the same shares that were shorted were re-purchased bythe original owner. The process was repeated until it was apparent that more sharesexisted than were actually authorized by the company and none remained available forshorts to cover. Vis-a-vis OSTK, according to Yahoo (finance.yahoo.com/q/mh?s=OSTK),insiders now own 70% of all outstanding shares and institutional and mutual fund ownersnow own 44%. Does anyone else find it of interest that 114% of the shares are nowreported as owned?! For the sake of argument, we have "decided" that the4.9 million share position of High Plains Investments has been double counted. HighPlains is owned by Dr. Byrne and could conceivably be counted as both "insider"and "institutional." Bear in mind this is only an assumption. Ifthis were true, insiders and institutions would still own 87.8%, placing the float at only2.28 million shares, the best case we can concoct for shorts. But how can shortshave sold nearly three times the available float?! Answer: institutions and otherlarge holders may have lent their shares for a premium, say 20% annually. Also ofnote, put positions alone may have resulted in market makers hedging with short positionsin the stock. We note that put open interest near the current OSTK strike totals theequivalent of well over one million shares that have conceivably been shorted, and it ispossible that many of these shares will never be delivered to their buyers. Inessence, counterfeit shares.
Ironically, while bears have loaded up and then reloaded on shortpositions, it is also possible that the same institutions that lent shares out to shortshave repurchased the very same shares that were loaned and shorted! Again, theequivalent of counterfeit shares have been created.
How can the stuff not eventually hit the fan? Clearly, Overstock either has more shares in circulation than actually exist or theavailable float is no longer sufficient to provide shorts the opportunity to cover withoutdramatically affecting the price of OSTK shares. Unfortunately for shareholders, thecurrent circumstance also implies that shorts can and will do everything in their power todrive the price to zero. The battle lines have been drawn.
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Volatility Still Low
Despite an uptick in the VIX, our volatilityindicators remain quite low. There is still no fear in the marketplace. Themost interesting aspect of our chart at top right is that months ago, we claimed the sametrading range in 2004 would suffice for most of 2005, and thus far, our highlighted boxhas held virtually all the action. The low point is SPX 1136.15, which we expect tofall in the next six weeks as volatility finally expands.
ABOUT ALAN M. NEWMAN
Alan M. Newman has been the Editor of CROSSCURRENTS since the firstissue was published in May of 1990. Mr. Newman is also a member of the Market Technician'sAssociation and has been widely quoted for years by the financialpress, media, and other newsletters and has written articles for BARRON'S.
The newsletter is published 20 times per year and focuses oneconomic and stock market commentary, often covering controversial subjects. Severalproprietary technical indicators are usually featured in every issue accompanied bycurrent interpretation. Broad samples of our work can be viewed at
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