19 Naked Shorts

As you sit in the Emergency Room with all the other investors who are trying to recover from this week’s market whiplash, here is something for you to ponder: “Why 19?”

On Tuesday afternoon the SEC announced temporary restrictions on “naked shorting” of certain stocks. Space precludes us from explaining in detail how it all works. Suffice to say that even though naked shorting has been practiced on Wall Street for years, some people think it is an abomination while others consider it benign or even beneficial. In either case, we have difficulty understanding what the regulators hope to accomplish with the new guidelines. First, if this practice is so problematic, why ban it for only 19 stocks? Why not all stocks? Second, the 19 Chosen Tickers are all large banks and financial institutions that are just as likely to benefit from naked shorting as to be victimized by it. Indeed, the list omits dozens of stocks that are much more actively shorted by bearish investors. Third, the new rule does not take effect until next week. If naked shorting is such a huge problem, why delay the solution? It is a curious way of solving a problem that may not even exist.

We have the utmost respect for the SEC and other regulators in these difficult times. Indeed, we are grateful for their efforts to protect the investing public. Nonetheless, it is hard not to conclude that this latest action creates at least the appearance of favoritism, if not the reality. Who decided on this group of 19 stocks, and what were their criteria? Why were some embattled institutions like Wachovia (WB) left off the list while relatively stable investment banks like Goldman Sachs (GS) made it? The logic is hard to follow. In due course the answer may become apparent, but for now it is a mystery.

One consequence of this enigma is that it is difficult to draw many conclusions from this week’s market action. While the rally in financials has been dramatic, the sector was deeply oversold and due for a bounce. Broad benchmarks like the S&P 500 remain in primary downtrends. Maybe the bottom is behind us, but we would not bet on it just yet.