Market Watch : Short Sellers Bet on Rally Fading

You’d think by now that the short sellers would be crying uncle. But many of these traders who sell borrowed stock--betting that they can replace it at lower prices later--believe that the market’s recent powerful rally won’t last and that prices will head south soon.

That’s true even of some of the individual investors who had never shorted a stock before last year. To be sure, quite a few of those amateur shorts covered their positions in the past few weeks as stocks soared. If you sold a stock short at $30 and it has since jumped to $35, you face a loss of $5 a share if you buy it back now to replace your loan. But that loss may look far more appealing than chancing that the stock will hit $50.

Still, many shorts believe that the bear market isn’t over, so they’re trying to maintain their stance.

Ken Luskin, a broker at Paine Webber in downtown Los Angeles who has been an active short seller, says his clients who play that game are staying the course. The difference between sophisticated and unsophisticated short sellers, Luskin says, is that the unsophisticated often try to short a stock as a proxy for a big short-term drop in the market overall.

In contrast, the smart traders don’t care whether the broad market goes up or down. “There’s a reason why they shorted a (particular) stock,” Luskin says. Many stocks his clients have shorted are expected to be hurt by the fallout from the debt buildup of the 1980s, Luskin says. His short sales include such names as Wells Fargo, Aetna Life and General Electric, whose finance arm was a major lender in the late 1980s.

At discount brokerage Jack White & Co. in San Diego, some individual investors were trying to short as recently as last week, says Robert Reed, executive vice president. “They were looking to short some of the blue chip stocks that are near all-time highs,” he says. Given the market’s strong momentum, “those people are very, very brave,” he adds.

How long can the shorts hold out? In theory, they can wait forever, because there’s often no time limit on replacing borrowed shares. But the deeper a client goes into the red, the greater the odds that the client’s brokerage will issue a margin call--demanding that the client put up more cash to compensate for the paper loss. That often forces a short seller to buy back the shares sold short.

“We’ve been sending out margin calls,” admits Steven Wallace, president of discount brokerage Pacific Brokerage Services in Los Angeles. “We’re tougher than a lot of other firms on this.”

What happens then can be seen in the accompanying table. The stocks listed were among the most heavily shorted on Jan. 15, just before the market rally began. Although the sharp advance in the stocks is partly the result of investor buying, they were also boosted by the action of the short sellers buying to cover their positions to meet margin calls. That double-whammy has sent the stocks far higher than they might have gone on their own.

If the market continues to work its way higher, more of the shorts will be squeezed into giving up and their buying will become new fuel for the rally. Many traders say there are still no signs that investors overall are turning pessimistic about the market.

On Friday, despite the news that the economy lost far more jobs in January than expected--signaling a deeper-than-expected recession--gaining stocks still beat losers by a 10-6 margin on the New York Stock Exchange. “There’s just not a lot of supply (of stock) around,” says Tracy Wheeler, over-the-counter trading chief at Seidler Amdec Securities in Los Angeles. “People keep waiting for the selling to begin, but it doesn’t happen.”

Nice Time for a T-Bond Sale: Last Friday’s bond market rally couldn’t have come at a better time, from the U.S. Treasury’s point of view. This week the government will auction a record $34.5 billion in notes and bonds: three-year notes Tuesday, 10-year notes Wednesday and 30-year bonds Thursday.

Last Friday, the yield on existing 30-year T-bonds tumbled to 8.09% from 8.19% on Thursday. The catalyst for the rally was the Federal Reserve’s surprise cut in its key discount rate, to 6% from 6.5%. The Fed acted, ostensibly, because of the jump in unemployment in January. But the credit easing also should make it easier for Uncle Sam to borrow his multibillions, which is extremely important as the government wrestles with the prospect of the biggest-ever budget deficit this year.

A. G. Edwards & Sons, the St. Louis-based national brokerage that does a big business selling Treasury securities to individuals, reports that investors are extremely hungry for the government’s three-year notes. John Fechter, a bond trader at Edwards, estimates that the average yield on three-year notes could fall as low as 6.95% at the auction, from 7.04% on existing notes as of Friday. “We find that a lot of our mom-and-pop customers want to get into short-term Treasuries because they don’t want to deal with banks or thrifts anymore. There’s more of a flight to quality than I’ve ever seen,” Fechter says.

And what about the 10-year and 30-year securities? At each quarterly bond auction, there’s always plenty of worry about who’ll buy the longer-term Treasuries. This time around, say some economists, watch for Middle Eastern investors--the Saudis, Kuwaitis, Qataris and others--to take the place of the Japanese as Uncle Sam’s big creditors. With Operation Desert Storm in full gear, it’s probably not too far-fetched to imagine Arab governments feeling subtle pressure to help Washington through a smooth bond sale.

THE SHORTS CAVE IN

How some heavily shorted stocks have jumped since Jan. 15, as the market rally has caused panic buying on the part of short sellers.

Shares short Stock price: Pct. Stock (millions) Jan. 15 Fri. Chng. Carnival Cruise 2.67 12 3/4 17 5/8 +38% Marriott 10.88 9 1/2 13 +37% Federal Express 1.16 32 7/8 43 1/4 +32% Wells Fargo 5.43 49 3/4 63 +27% Security Pacific 5.16 17 7/8 22 1/8 +24% Fed. Natl. Mtg. 10.75 34 40 5/8 +19% S&P; 500 313.73 343.05 +9.3%