Category Archives: short selling

Has Chairman Powell Learned From His Terrible Mistakes?

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For years the talking heads and their guests on cable news endlessly chattered about interest rates remaining near zero in the US and negative in Europe. They talked of the “new normal”. However, some complained that interest rates had remained too low for too long and of the importance of raising interest rates and reducing the Fed balance sheet so that the Fed would have powder to fight a downturn in the economy. Upon his becoming Fed chairman, Jerome Powell quickly demonstrated that he believed in the latter approach.  We were in un-chartered territory. Never before had interest rates been so low for as long  or had QE been used to such an extent. There was talk about a neutral rate of interest. They hadn’t learned that just as every reduction in interest rates or expansion of the Fed balance sheet had spurred the economy, every raise in interest rates or reduction in the balance sheet negatively impacts the economy.  The interest rate and size of the Fed balance sheet you are at at any given time can be considered neutral because any increase in the rate of interest or sale of Fed assets slows the economy and any decrease in the rate or purchase of assets stimulates the economy.

Although the economy was growing and there was no sign of inflation when he was appointed, Chairman Powell chose not to wait patiently. He began his chairmanship by raising interest rates and reducing the Fed’s bond portfolio much too quickly. He did so at a time when the growing economy and rising corporate profits were beginning to generate additional federal tax revenues which would have reduced the federal deficit. As predictable his actions negatively impacted the economy and the stock market which went into a steep decline. His final 1/4 point raise of interest rates in December of 2018 while the stock market was collapsing was not just stupid, it was idiotic. To make matters worse he recklessly announced plans for further rate increases and balance sheet reductions in 2019. His actions were instrumental in killing the momentum that the corporate tax cuts (a once in a generation stimulus) had generated in the US economy and raised a serious likelihood of causing a downturn in the US economy. Corporations that were already spooked by President Trump’s attempt to level the playing field in trade by imposing tariffs, immediately began to reconsider and postpone capital investments.

After being strongly criticized by President Trump and many others he quickly reversed course, He announced that further rate increases would be delayed and introduced the concept of “patience”. This word selection demonstrated that he either still didn’t fully understand his prior mistakes or that he wouldn’t acknowledge them because he wanted to show he was independent and wouldn’t bow to President Trump’s wishes. What he obviously meant by “patience” was that he would delay further increases. He didn’t recognize that rates were already too high and that the December increase should have been reversed. However, cancelling intended further rate increases did stimulate the stock market and permitted economic expansion to continue. Recently when corporate earnings came under pressure and the stock market went into a tailspin again based in large part on trade and border issues and a lack of infrastructure spending, he took notice of the market decline and the possibility of a coming recession by talking about potential interest rate cuts this year. Although he slowed Fed asset asset sales he did not discontinue them to the chagrin of President Trump.

Chairman Powell appears to be learning on the job. I ask if he has learned too little, too late. At the June meeting of the Fed he recognized that the Fed can take preventive steps to extend economic growth and avoid a recession rather than waiting to reverse one. He also recognized that governmental actions relating to trade and  Congressional failures to act should be taken into consideration by the Fed. But, he should have acknowledged his prior errors and reduced interest rates. Although we can expect a rate decrease in July, I fear he still does not appreciate the desirability of low interest rates for an indeterminate period or of growing the economy at a rate in excess of 2% a year and will be more concerned with appearing to be independent. Instead of worrying about his independence, he should be coordinating with administration officials to be better able to coordinate Fed policies with fiscal policy. The Fed’s independence is assured by statute. Its actions do not need approval of the President or Congress. Its role in ending the Great Recession was important to our prosperity. However, when it makes serious mistakes it should welcome criticism from the President and others. Whether or not he can be replaced as Chairman by the President, when the Fed chairman makes repeated errors he should resign.

Since he has spent his time thinking about interest rates and the Fed balance sheet, it seems unlikely that he now recognizes or has even thought about the risk that market factors which might cause a stock market collapse present a similar risk to the US economy as existed in the 1930’s.  As I have written recently he could have worked with the SEC and taken steps to reduce stock market manipulation and volatility and the risk of a stock market collapse which might follow or lead to a serious recession or even a depression. The overheating of IPO offerings in recent weeks has been fueled by increased margin borrowing on both the long and short sides of transactions.

He has recently talked of living with inflation even if exceeds the 2% guideline of the Fed. However I expect that he would probably panic and choke off the economy if it accelerated again (as it could if we spent trillions of dollars on needed infrastructure for highways, bridges, airports or security, or if we spent to limit the effects of climate change by upgrading levees and dams to control flooding or built an interstate fresh water pipeline (the most important project of this century) and began to grow our economy at 4, 5, or 6 %. I expect he would fear inflation even though the causes of inflation were absent. Robots are coming and they will make employees available for non-inflationary economic growth thereby enhancing the Amazon related deflationary effects on the economy. China builds new cities. Why can’t we upgrade ours instead of letting widespread crime turn them into slums? Of course we would have to deal with the limits of available raw materials and the socialist jerks who would argue that the rich are getting richer even if we were creating millions of high paying jobs for a large number of currently low income workers and generating tax revenues to enable us to pay for for the greatest welfare state the world has ever known.

The Fed’s role is important. Unless our economy grows at a satisfactory pace, the rising number of politicians chanting for socialism may in a short time lead to the end of the great American capitalism experiment.

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PREVENTING STOCK MARKET CRASHES

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After every stock market crash we search for the causes and change rules and regulations to prevent future recurrences. Politicians are not well suited for the task. It is unlikely that the current rules and regulations will prevent a future crash because they fail to prevent or adequately limit use of practices which exacerbate market declines such as short selling, stop loss orders, chart theory and excessive margin buying which leads to margin liquidations in declining markets. Managers of many large pools of capital understand the effects of such practices and execute trades timed to further enhance extreme market declines so that they can then become buyers after the precipitous decline.

The talking heads on financial news networks have speculated lately on whether a 20% stock market decline like the one that occurred on October 19,1989 might occur again. They discuss the fact that a 600 point decline in the Dow is currently only about a 2% decline and that a 20% decline would amount to more than 5000 points in the Dow. They often talk about the differences in the US economy between 1989 and now, the possibility of a recession, the strength of corporate earnings and balance sheets, the trade war with China, tariffs, the effects of negative European interest rates, the rate of inflation and the Feds current stance on interest rates and its balance sheet. However, I haven’t heard them talk recently of governmental regulations or controls in place to prevent the recurrence of a 1989 type decline. The safety net value of current regulations and controls in place were about to be tested last year until the Fed reversed its course on interest rates after raising interest rates too fast and projecting ridiculously stupid further interest rate increases and balance sheet reductions. Has the Fed already forgotten the result of its successful policies which enabled our economy to escape from the Great Recession. Does the Fed understand that excessive stock market declines can lead not only to a recession, but as in the 1930’s to a depression? Fed chief Powell stupidly talks of patience when he should have admitted his error in adopting overly restrictive Fed policy decisions. 

Most of us learned from old western movies that a rancher who wishes to avoid a stampede of his horses or cattle builds secure fences or takes precautionary measures when moving his herd. Our current securities regulations and controls which are designed to stem an out of control decline were influenced by investment bankers seeking to maximize their profits by encouraging speculative practices in disregard of stock market stability. Brokers profit from charging high rates of margin interest and charging short sellers for borrowed stock. Speculators often profit in declining markets from short sales at declining prices made possible by the elimination of the uptick rule. A combination of factors acting in concert, including short selling at declining prices,  stop-loss order liquidations, margin calls, tax selling, reaching chart theory sell points and panic, cause stock price declines to be exaggerated.

Now is the time to take action to change the government regulations and controls of the securities markets to greatly reduce the probability of a crash. The Fed and the SEC should work together. Here is what I propose:

  1. The SEC should immediately reinstate the uptick rule and prevent way to avoid it. It was lunacy to remove it.
  2. The SEC should ban all new short selling when  any of the Dow, S&P or the NASDAQ averages (the “leading market averages”) have declined more that 20% from their 6 month highs; and continue the ban until all such averages have recovered at least 10% from their low point after the ban is put in place.
  3. The Fed should limit the risk of margin liquidations by changing margin requirements to provide that aggregate initial margin in an account shall be reduced to 40% during each 30 day period after which any of the leading market averages has hit a 12 month high.
  4. The SEC should change the way stop loss orders operate. Make them become good until canceled limit orders and not market orders when the stop loss point is reached. This will reduce the avalanche aspects of sales at declining market prices and discourage misplaced reliance on the protection of stop loss orders.
  5. Try to reduce dumping of large numbers of shares by active traders by charging a small fee on the dollar amount of all sales of securities held less than 5 years.

The Feds goal of full employment is negatively impacted by stock market declines. A reduction in the wealth of investors negatively impacts their spending. The Fed should stop talking foolishly about “patience” and clarify that it intends to reduce interest rates and engage in QE whenever stock prices decline significantly.

The Twitter Stock Price Roller Coaster

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In the short time period since the Twitter IPO its stock price has performed as if it was riding a roller coaster.  Various factors have contributed to its meteoric rise to a peak, followed by a rapid decline. Market factors unrelated to the fair market value of Twitter shares have influenced the price movement. Prior to the Twitter offering, IPOs were in a state of great demand (which occurs from time-to-time) with investors of most IPOs being allocated less shares than requested. Many investors were purchasing  the unallocated portion of their subscription as soon as the IPO commenced trading. The Twitter offering was highly glamorized by the financial press. Twitter shares like those of many other IPOs immediately skyrocketed in price. Twitter has many loyal users who were unable to obtain an allotment on the IPO and they and other investors for various reasons elected to buy the shares in the after market. Chart theorists added fuel to the fire as they determined buy points as the Twitter stock price rose and gathered momentum. As the stock price rose far above the IPO price it attracted short sellers. However, as ofter occurs when short sellers sell into a rapidly rising market, they get squeezed and panic, one-at -a-time, and cover their shorts at ever increasing prices, thereby driving the stock price higher. 

When the price of Twitter shares peaked and started to decline, various factors, acting in a manner similar to the way that gravity effects a roller coaster car, precipitated the decline. Some analysts withdrew their support based upon market capitalization and recommended sale . Stop loss orders, which have become fashionable and which were placed at various levels during the share price increase, began to be executed at declining prices, creating selling pressure. Chart theorists interpreted sell signals. Short sellers, who follow the analyst reports, know about the existence of stop loss orders and understand chart theory, exacerbated the decline by selling short at declining prices. As the stock declined, margin calls and tax loss considerations came into play and some unsophisticated stockholders sold in panic. 

Like a roller coaster the ride will stop at the bottom. If Twitter can generate revenues and profitability from its large number of followers, its shares will begin to rise again. If, as I expect, the rise occurs, the SEC should conduct an investigation as to when every short sale took place to try to determine the role of short selling in exaggerating stock market declines.

Short Selling Does Not Promote Pricing Efficiency

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Only fools, who do not understand the interplay of short selling with  chart theory, stop-loss orders, margin calls, and panic selling in market downturns, think that short selling is a price discovery mechanism that leads to pricing efficiencies. In fact, it generally exaggerates price swings. Short selling is often used as a manipulative device and it should be banned or carefully regulated. The up-tick rule should be reinstated immediately. In addition, all short selling in a security should be banned when its price has declined substantially from its 52 week high.

You should read the short chapter entitled “Short Selling and Stock Market Manipulation” in my book entitled “Perpetuating American Greatness After The Fiscal Cliff”. My earlier book entitled “Homeland Security And Economic Prosperity” written after 9/11 and the bursting of the .com bubble, but while the up-tick rule was still in effect, proposed strengthening the up-tick rule to prevent bear market raids by short sellers. Subsequently, the SEC ignored the bear raids in 2007 and 2008 and ignorantly eliminated the up-tick rule. My original paper on the subject was written while I was a third year law school student in 1963. Since then SEC regulation of bear raids has gotten worse, not better.

Beware Of The Role Of Short Selling And Stop Loss Orders In The Current Market Decline

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For months we listened to investment experts on financial news programs advise investors to protect their positions against a market correction by using stop loss orders. As stock prices rose investors, who heeded the advice of these experts, placed stop loss orders at increasing price levels. As a result an inverse ladder of stop loss orders was created. When international currency issues and other factors set off a moderate market downturn some of the highest stop loss orders were automatically converted into sell orders and the market decline accelerated. Short sellers who have been on the side lines were able to accelerate the decline by selling short on downticks. They know the price on stock charts that chartists interpret as a sell point and begin to sell short on downticks in an attempt to encourage sales by chartists, the execution of stop loss orders and panic by fearful investors. The combination of stop loss orders, chart theory, short selling on downticks and ultimately panic and margin calls may set off a stampede leading to further market declines. Domestic and international economic growth are important to stock market activity, but the above described technical factors have a significant impact during a stock market market decline that may, because of the wealth effect and fear, lead to a downturn in economic activity.

A Sense of Fairness

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We CAN AND SHOULD change our federal tax laws to encourage cash rich corporations and individuals to invest in a new type of Jump Start America Bonds to improve our transportation infrastructure, create jobs and jump-start the growth if America.

We CAN AND SHOULD change our mortgage laws to assist homeowners with under-water mortgages by reducing the principal amount of their mortgages and end the housing crisis.

We CAN AND SHOULD change the federal income tax laws to treat income earned in the form of a carried interest for managing other people’s money as ordinary income.

We CAN AND SHOULD change the federal estate tax laws to limit the use of foundations and require all taxpayers to pay an estate tax of at least 20% of their assets in excess of $10 million dollars.

We CAN AND SHOULD change our federal securities laws to prevent traders from time-to-time acting like robber barons by manipulating stock prices downward.

We CAN AND SHOULD increase our defense spending to strengthen our security and grow our economy.

We CAN AND SHOULD modify our healthcare system to fairly reward healthcare providers for making available the highest quality care which achieves the best outcomes; offered and equitably distributed at a cost which is affordable by the corporations, individuals and governments who are paying for it.

We CAN AND SHOULD regulate our banks to limit their risk taking to enable them to maintain strong balance sheets and provide needed banking services for their customers in an equitable manner.

Perpetuation American Greatness After The Fiscal Cliff discusses how we can accomplish each of these goals.

Perpetuating American Greatness After the Fiscal Cliff

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March 10, 2013

President Obama insists on a balanced approach to raise taxes and cut spending to reduce the federal deficit. Both raising taxes and reducing spending will hurt our economy. He doesn’t really want to cut spending. He says he is willing to address entitlement problems (which were made worse by Obamacare), but he offers only vague solutions which fail to address the real issues of excessive and growing Medicaid, Medicare and now Obamacare expenses.  Squeezing drug suppliers, doctors, hospitals and insurers to reduce medical care costs is going to reduce the quality and availability of care.

The Republicans were bludgeoned by the president’s misleading demagoguery into raising taxes which they didn’t want to do. They want to cut government spending to reduce the National Debt, but austerity measures are likely to cause a recession and increase, not decrease, the federal deficit. They are using the sequester to cut the rate of growth of government spending. The sequester has been politically successful for the Republicans by exposing President Obama’s demagoguery and scare tactics. However, it requires across the board cuts and, even if modified, will reduce defense spending and result in job losses (as all federal spending cuts do). President Obama will blame everything which may go wrong in our country during the next four years of his presidency on the Republicans even if he has throughout his presidency been weakening our defense and most of the job losses will result from the 2013 income tax increases and the adoption of Obamacare and Dodd-Frank.

Neither party has proposed a plan to promote job creation and economic growth which will come to the aid of the forgotten middle class, increase tax revenues and reduce the federal deficit. Our politicians do not seem to understand that the goal should be to grow the GDP at a faster rate than the the rate of growth of the national debt.

My book entitled Perpetuating Greatness After The Fiscal Cliff examines the economic events after the turn of the century leading to the fiscal cliff and the myriad of problems facing our economy resulting in large part from government failures. It suggests solutions to our economic problems including:

1. Proposed corporate income tax and estate tax law changes to encourage our cash rich corporations and individuals to step up and invest in state transportation infrastructure construction projects to create millions of jobs;

2. A federal mortgage law to eliminate underwater mortgages by enabling homeowners to obtain restructured mortgages and reduce the aggregate of their home mortgages to the fair market value of their home;

3. Ways to modify our entitlements to make them affordable and available to provide quality health care.

4. Modification of the federal income and estate tax laws (including the 2013 tax law changes) to make them fair and to close loopholes to raise revenues without harming economic growth;

5. Changing Dodd-Frank to strengthen bank regulation while eliminating certain provisions which are unnecessarily restricting economic growth;

6. Changing securities regulation to prevent current manipulative practices and the next stock market crash by restricting manipulative short selling practices;

7. limiting interest rates on consumer credit by the adoption of a national usury law;