SEC Engineers Massive Short Covering Rally

I will come back to pension plan governance tomorrow. Today was a day for bulls to finally smile as financials led the way for a broad market rally.

But there is more to this massive rally than meets the eye. Behind the scenes, the Securities and Exchange Commission is investigating more than 50 hedge fund advisors for illegal insider trading or stock manipulation.

On top of that, the SEC introduced tough new rules to limit short sales of Fannie, Freddie and brokers. Apparently a number of hedge funds have being engaging in naked short selling, in which traders never borrow shares from their broker or deliver the stock to buyers.

I quote from the Bloomberg article:

The SEC had been reluctant to curb short sales "because it would require a major retooling of the plumbing of Wall Street,'' said James Angel, a professor at Georgetown University studying short sales. "It's only when the big Wall Street firms are threatened that the SEC does something about it.''

Cox said the SEC also will draft rules "to address these same issues across the entire market.''

Moreover, the SEC's proposal will raise the cost of short-selling a stock:

The order, published today, requires anyone making a short sale to first "borrow or arrange to borrow'' the securities and then deliver them by the settlement date. It applies to shares in 19 firms including Citigroup Inc., JPMorgan Chase & Co. and UBS AG.

The order takes effect on July 21 and expires at the end of July 29. It may be extended for a total of 30 calendar days.

As shown in the table above (click to enlarge), all the dogs rallied strongly today, including Fannie Mae (+31%), Freddie Mac (+30%), Lehman (+26%), and Washington Mutual (+25%). Wells Fargo, the only "solid" financial in that group. rallied 32% today after the company announced it was increasing its dividend to 10%, much to the dismay of some analysts who heavily criticized this move.

The good news sent the whole financial sector up, sending the UYG (Ultra Proshare Financials) up by 23%. And all this happened in one day!!! In fact, the whole market followed in unison except oil shares which fell again as oil prices tumbled from last week's highs.

The big question on every investor's mind is whether or not today was "THE" bottom. I warn people that today was nothing more than a SEC engineered massive short covering rally. Financials were way oversold and due for some relief rally. This relief rally will likely have legs but investors should use this rally as an opportunity to reduce their exposure to financials.

Why am I not convinced that this was "THE" bottom? Because there is evidence that the U.S. economic weakness has now spread to Europe:

Spain, Ireland and Denmark are either in, or on the brink, of a recession. Italy is stagnating. France is weakening fast. And Germany, the sturdy locomotive of European growth, is suddenly faltering - dashing most residual hopes that Europe could escape the upheaval in the United States.

The only thing left now is for some bad news to come out of Asia so we can officially pronounce this as a global economic recession. I never bought the "decoupling theory" which basically states the rest of the world has decoupled from the United States. I expect some important economic headwinds will hit Asia as well as commodity rich countries like Canada who have so far escaped the fallout from the U.S. storm.

But today the bulls were in control. We'll see how long this rally lasts. My hunch is that Wall Street will try to make it last for a while to reel in more suckers. Keep an eye on the UltraShort Financials ETF (SKF) as it declines. Once reality sets in, this will be the ETF to invest in again going into 2009. (You can read all about Proshares by clicking here).

I end it off with a quote from this excellent article from the TIMES of London:

The biggest immediate threat, though, is the health of the financial system. There is a deepening mood of uncertainty in the US. The simple inescapable fact is that the value of US houses and stocks is 20 per cent or so below where it was two years ago. That will require a prolonged period of retrenchment by American consumers and businesses as they adapt to their reduced wealth.

More worryingly it will almost certainly require the US Government to put up perhaps hundreds of billions of dollars in hard cash as a floor under the tumbling financial system. Those queues outside the Indybank branches in California were not really necessary – the Government guarantees everybody’s deposits up to $100,000. But more collapses like that will put great pressure on America’s public finances and that could push the dollar even lower, adding a new leg to the downward spiral already under way.

It will end, of course, in time. House prices will fall to a level at which they look cheap again. Banks will finally clear the backlog of dead and dying assets from their books.

In the process, demand will weaken sufficiently to bring down the price of goods such as oil and food and the inflation threat will pass. Central bankers in Washington and around the world seem to think that this process will take at least another year or two. And in the meantime they – and we – can only hope that the route from here to there is a straight one.