Friday, October 31, 2008

Short-Covering Rallies, Explosive and Brief

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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On Monday night New York time, the Nikkei in Japan hit a new intraday low dipping into the high 6000s (it was almost 40,000 at its peak in early 1990). An hour or two of sharp trading in either direction means very little in current market conditions though and the Nikkei reversed and closed up 6.4%. South Korea had the opposite trading pattern, being up 8% during the session, but closing down 3%. The Shanghai deposit had a similar loss and Singapore and Taiwan were flat. The sharp drops, which have been going on for some time in stock markets throughout the world, indicate increasing short positions. Eventually, the shorts become so large they create an unstable situation that can lead to sudden and explosive rallies.

This was no more clearly illustrated than when trading in Asia was winding down and Europe opened. A short squeeze in Volkswagen caused by Porsche announcing it was increasing its stake in the company caused a 348% rally in Volkswagen stock in only two days. Volkswagen briefly became the largest company in the world based on market capitalization (this would be a nonsensical claim by any other criteria). Volkswagen is part of the the DAX in Germany and its weighting in the 30 stock index rose to 27% creating a massive move up in the DAX as well. It was soon announced that Volkswagen's weighting in the DAX would be adjusted down to 10% in order to create a more realistic pricing situation. A number of major U.S. hedge funds and Goldman Sachs were caught on the wrong side of this melt up. While some media reported that Volkswagen experiencied the largest short squeeze ever, its price move pales in comparison to one that took place in Northern Pacific stock in the U.S. during 1901.

On Tuesday, the U.S markets opened with a strong bullish tilt, but at least at one point it looked like they would turn negative. A rumor in the afternoon that the Fed would cut rates to zero caused an explosive end of the day rally (neither truth, nor realistic claims are necessary preconditions for short squeezes). The S&P 500 ended up the most rising 92 points or 10.8%. The Dow was up 889 or 9.8%, the Nasdaq 144 or 9.5%, and the Russell 2000 trailed with a rise of 34 or 7.6%. The financials (the most shorted of all stock groups for good reason and despite the recent ban) had their biggest rally in history. Equally massive rallies took place that evening in the beaten down Asian indices, with Japan up 10% and South Korea 12%.

The U.S. Fed then announced at the close of its two-day meeting on Wednesday that it was cutting interest rates 50 basis points to 1% (the same interest rate that gave rise to the current credit crisis). Since this cut was expected and some traders were obviously looking for a lot more, it should have been more than fully priced into the market. Nevertheless U.S. markets rallied initially, but sold off at the very end of the day. On Thursday evening Japan followed up with its own rate cut of 20 basis points, leaving interests rates at just 0.30% (they've been lower there). The U.S. Fed will probably be getting close to that level soon enough. Japanese stocks fell 5% on the news because apparently the market wanted more. Technically speaking this was a stock market crash, but a drop of this magnitude has become so common in the last two months that no one pays particular attention anymore.

NEXT: U.S. Election's Impact on the Market

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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