In fall, 2008, the US banned short selling of certain stocks.  It triggered a massive short-covering rally.  Then, without the shorts in the market, prices went into freefall.  When prices are falling, the shorts (when taking profits) are the only bidders.  Markets don’t crash because of short sellers.  They crash because the bid is withdrawn.

Every time governments have tried to manipulate markets and impede price discovery, it’s always had the same disastrous result.  And yet today, several European countries have announced bans on short selling.

My prediction is that, after a possible massive short covering rally and possibly piling-on by momentum chasers, whatever securities are not shortable will collapse.  One reason for this is that a ban on short selling tells would-be buyers that there is something wrong.  And they should withdraw their bids.  Then gravity will take over, as first one seller needs to sell “at the market” (i.e. on the bid) and there is no real bid.

I wrote the following in response to a friend’s Facebook post.

First, contrary to popular misconception, the purpose of the stock market is not to go up, ratcheting higher and never lower. Its purpose
is price discovery. This is because it allocates capital, and just as it is important to allocate more capital to the most productive
enterprises, it is equally important to deprive the least productive enterprises of more capital (which they are destroying). Short selling
is a key part of this process.

Second, unlike long buying, short selling tends to be done by more sophisticated investors. With long buying, there is a limit on one’s
potential loss but no limit on the possible gain. Short sellers face the opposite: a limited gain and unlimited losses. This tends to make
them more careful, more selective, and to hold positions for much shorter periods of time.

Third, short sellers keep everyone else honest. When people can act free from negative consequences or downside, they tend to become more
and more aggressive and take risks. Imagine if I said go into the casino, and if you win keep it. But if you lose, I will pay you back.
This is also called “moral hazard”. Greed is one of the two motivators for market participants. People want to make lots of money. Fear is
the check on it. People really want to avoid losses. Short sellers can inflict losses when people become overly, irrationally greedy.

Fourth, short sellers will tend to dampen volatility. The higher a price goes above its fundamentals, the more short sellers will be
attracted to come in to the market. Perhaps more dramatically, when a market is plunging, short sellers may be the only bid in the market.
Consider how a real market works. Forget “the price” of something.  There are always two prices: the bid and the ask (offer). The bid and
the offer are made by different people, motivated by different forces.  And there are asymmetries. Since money is the most liquid, most
trusted thing in the system, it’s never bad to sell an asset and get cash. So there is never a case when the offer is withdrawn. But the
bid is a whole different story. The bid is withdrawn under crisis or stress. This causes a market to plunge, and thus more bids are
withdrawn. Short sellers, on the other hand, have a natural tendency to want to take profits. And thus buy back the shares they shorted.  And thus put in a bid.

Fifth, markets are driven by arbitrage. If the price of copper goes down, an arbitrager can put on the following trades simultaneously:
buy copper (long) and short a copper mining company. If two similarly situated companies are trading at a stable ratio of share prices, and
one’s price suddenly starts to collapse (assuming that it’s not caused by anything real) the arbitrager can buy the fallen shares and short
the shares of the other to bring the spread back to normal. There are endless examples of arbitrage, which involve at least one short “leg”.

The Swiss franc has risen from $0.86 in Jun 2010, spiking to more than $1.40 yesterday.  Unfortunately, I did not have time to write this piece before its mini crash overnight.  It was down more than 5% when I turned on my screen this morning.

So what’s going on with the Swissie?

No one outside the the central banks and their cronies knows the details of what’s happening or what will happen.  But one can apply general principles and put together a big picture.  That is my goal in this today.

Most people who have observed markets for any length of time can tell you that gigantic moves upwards after a long period of relentless upward moves generally do not end well.  Silver had a massive spike to $49, before selling off to $34, a 30% crash.  On Tuesday, Aug 9, the Swiss franc (CHF) moved from $1.32 to $1.39.  Two days later, it has moved (so far) from $1.37 to $1.31.  It’s currently below the opening price on Tuesday.

Whenever a price gets far enough out of whack, it tends to get back into whack.

OK, but this is just chart watching.  I am not generally a believer that past price movements can predict future price movements.  Let’s look at the fundamentals.  First, the swissie is like all other “modern” currencies today: it is the debt paper issued by a central bank.  

http://www.zerohedge.com/news/swiss-franc-plunges-600-pips-peg-speculation-wi…

A must read:

http://www.thedailybell.com/1052/Antal-Fekete-The-New-Austrian-School-of-Econ…

People interested in gold need to get past the false linear quantity theory of money!

One of the conspiracy theories that’s popular in the gold community right now is that when the CME and various brokers increased the margin required to hold silver, this caused the price to fall from $49 to $34.  Of course, observing the silver basis does not confirm this claim.

Today, Zero Hedge has a short piece allegedly explaining why the price of gold fell in a short time from $1680 to $1660: http://www.zerohedge.com/news/margin-calls-force-start-gold-liquidation

This is an attempt to have it both ways.  On the one hand, “prices should not be set in the futures market” according to GATA and Ted Butler.  On the other hand, margin calls (which obviously do not apply to physical metal holdings) can and do cause the price to drop sharply.

I don’t see how one can get much of an understanding of the gold market from such hit-and-run pieces, much less actually try to trade and make money!

One of my goals for this blog is to discuss gold and silver without the breathless conspiracy theories.  More later…

Charles Hugh Smith may not call himself a socialist.  But I’ve always found this altruist, collectivist, populist undertone to his writing.  Let’s see what he wrote today.

http://www.zerohedge.com/article/guest-post-you-want-fix-us-economy-heres-start

He has an 8-point plan to fix the economy.  The first thing I’ll note is that he does not address the punitively low rate of interest set by our expert central planners at the Fed.  There cannot be a fix to anything if we leave central planning of money, credit, interest, and discount under the control of an economic dictator.  And there cannot be a recovery without savings, which certainly is discouraged by Zero Interest Rate Policy.

Anyways, 6 out of the 8 points are about marking various asset categories to market value, punishing fraud in this marking, and putting banks into receivership if they are insolvent under the new rules.  It sounds good, upon superficial examination.  But upon deeper thought, he’s missing something important here.

The purpose of financial statements is to present a conservative and realistic view of a business, not a speculative view of how good things could be.  One must consider assets and liabilities slightly differently.  Assets should be kept on the books at the *lower* of either: (a) acquisition price or (b) current market value.  If an asset’s price goes up, it is not normally appropriate for a business to mark it up.

Liabilities, on the other hand, should be kept at the higher of either: (a) acquisition value or (b) market value.  If the liquidation value of a bond goes up, the debtor must show that as a loss of capital.  Otherwise, the balance sheet does not show the true picture.  If this rule were implemented, then the devastating effect of falling interest rates would be obvious.  Those “free” capital gains won by bond speculators come from somewhere: the capital accounts of bond issuers.

It’s hard to fault Smith for not understanding this.  Hardly anyone does.

But two of his points are something else altogether.  One of them proposes to give a free house to anyone whose lender committed any kind of fraud–even if they misrepresented risk to their investors.  This is arbitrary, capricious, and will have massive consequences.

The other was to allow bankruptcy to discharge student loan debt.  I think Smith is motivated by the idea of “soaking the rich bankers” and giving a freebie to people.  I would agree for a different reason.  We need to get rid of the special cases and special exceptions in our legal code, and return to the rule of law.  Either it is fair and proper and moral for people to be able to erase debt through personal bankruptcy, or not.  Either way, student loan debt hardly merits its own special treatment under law.

This is a short video I did on inflation and prices.