Shorts Get Scared

The government threw a wrench in the market this week deciding that prices, apparently, had gone low enough. The SEC literally changed the rules of the game in the stocks of nineteen major financial firms this week. Starting Monday, in a rule set to expire in 30 days, shorts must first locate the stock they will borrow to sell prior to initiating the trade. Previously, a short could initiate a trade if he had some kind of reasonable assurance that he would be able to borrow the shares. With this change the SEC aims to eliminate naked shorting, "the illegal practice of short selling shares that have not been affirmatively determined to exist" (investopedia.com). A good decision or not, this emergency decision has altered the functioning of financial markets.

Traders do not fully understand how this rule will affect the current market but it incited fear in the shorts. The government marched out Secretary of the Treasury Henry Paulson, Federal Reserve Chairman Ben Bernanke and President Bush trying to calm the markets. The pervasive confusion surrounding the new shorting rules compelled many risk-adverse traders to cover their short positions. This panic from the short side ignited a 25% oversold bounce in the financial sector. How manufactured is this rally? It is yet to be seen.

Oil's incredible tumble this week provided much needed support to the markets adding fuel to the rally. Oil failed to breakout in its last push from a consolidation period, broke its long-term uptrend and then key support. The rapidity of this sell-off gave investors hope that perhaps the top is in.

CNBC was filled with pessimists today all believing this bounce is unsustainable and will not last. I think this is a great contrarian indicator as markets tend to make the most people wrong. I think this rally will last longer and go further than most think it will. I need confirmation to believe that this bottom will propel us to new all-time highs but over the next few weeks I think we will see surprisingly higher prices. Then, we will find that CNBC is filled with optimists telling everyone to buy every dip and we will have topped. The 25% bounce may seem overextended but the financial sector has been the market's punching bag for a year now and long-term investors are far from impressed by a comparatively small 25% bounce off the lows.