Monday, August 17, 2009

Squeezing the Shorts

This blog has presented a macroeconomic theory over the past year and a half, which examines money supply, bailouts, and equates inventory with money supply and considers the consequences assuming that relationship to hold true.

But in terms of day-to-day fluctuations of the stock market, and even sustained runs, my guess work has not been good, and were I playing a shorting game, even though I am as much a bear as anyone, my guesses as to when fluctuations were to take place have been so bad I’m sure I would have lost my pants.

Part of it is the activity of bailouts of the falling economy, which is at best kept discrete and at worst hidden from the public eye. Bailouts allow upswings to go on longer than they should. But shorting is another factor which allows a bear run to enjoy one last moment of triumph when all looks hopeless. Which I’d like to comment on today. So I propose three phases to a bear run to help predict or at least better understand the natural course of upswings during a generally down market (or “bear runs”):

1. The Run: all bear markets have reversals of course. In the panic of a down market the indices will overshoot, which will be followed by a reactive upswing. This results from the inevitable imprecision of market pricing, which worsens during strong or unexpected periods of change—in other words, sinusoidal amplitudes that surround mean pricing only worsen. To predict the course of the bear run, one guesses what the mean pricing of stocks should be at a given moment, and the degree that the fall went below that average. The rebound should overshoot the "true" value by a similar amount.

2. Doubt and Shorting: when that moment comes to pass, and indices start to level off, and we all think the run is over, then since many people are expecting reversals of the market, shorting will be prevalent.

3. Squeezing the Shorts: however, if many people short the market at the same time, a third dynamic comes into play. Prices of stocks are determined by what buyers are willing to pay, and what sellers are willing to accept. With many shorts in play, those who possess the stock know that shorters HAVE to buy stock at whatever price it is at when the short sale comes due. At that time, there will be intense demand for the stocks, and since shorters have no choice, an extortion game can be played where shockholders wait it out for excessively high returns. And so we see sudden spikes of stock prices at the end of “bear runs,” right after it has started to level off.

4. Recycling: now, seeing this uptick can potentially arouse confidence and produce another run, albeit smaller, until shorters are exhausted and the run loses all confidence.

Then and only then will there be a down swing in the market.

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