Evolve or Perish

 | Aug 12, 2011 | 9:09 AM EDT  | Comments
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"The short-sale ban really smacks of desperation. That's their plan for solving the euro debt crisis? I mean, this isn't going to buy them much time."

--Kenneth S. Rogoff, professor of economics at Harvard University

For the first time since the 1987 crash, the market has swung more than 4% on four successive days. You have to go back to the 1930s for another bout of such volatility. This sort of action has only occurred a handful of times in history, so I don't need to belabor the point that we are dealing with truly unusual market conditions, which means we had better adapt if we want to survive and prosper.

The big jump Thursday is being helped this morning by a short-selling ban in France, Italy, Spain and Belgium. The obvious goal here is to try to stabilize markets and restore confidence while the European Central Bank deals with the euro-debt crisis. It may sound good in theory, but you have to wonder how effective that course of action will be.

In 2008, the U.S. imposed a similar ban on short selling. The announcement had a positive effect initially, but once it went into effect, the financial sector continued to trend down. The use of options and exchange-traded funds undermined the effectiveness of the action and, historically, short-selling bans have not worked well.

In 2008, a SentimenTrader.com study of short-selling bans found that after initial positive reaction to governmental intervention, the issues that prompted the action didn't go away and eventually weighed on the market again. Market players are a creative group, and they always find ways to put on the trades they desire. The politicians might slow them down a little, but seldom stop them.

I'll let others debate the wisdom of these policies but for trading purposes, all we really need to know is that short-selling bans usually have a short-term positive impact before the inciting conditions assert themselves again. Market players are not stupid, and they will be very quick to fade strength caused by this action, so we need to be very careful about trusting the upside created by this news.

Developing a strategy for dealing with this market is extremely difficult. Stocks are highly correlated, so there isn't much benefit to individual stock picking. As I mentioned yesterday, I've nibbled at a few stocks with strong fundamentals. While that may provide some support, I don't expect that to be enough to avoid pullbacks should the market continue to struggle.

Eventually, macro concerns will ease and we'll return to a market where stock picking matters. But today is not likely to be that day. We need to stay ready and make sure we have identified the stocks we will favor when the market returns to normal action. It is important to stay vigilant. And there is great potential for intraday trading with moves of this magnitude. Using your favorite long-term stocks as trading vehicles is a particularly good strategy as they will hopefully have some natural underlying support.

If you want to participate in this market, you have to focus on trading market direction rather than stock picking. If the recent pattern of action holds, this slightly positive open is a good time to put on some shorts. What has been happening lately is that as soon as some intraday direction is established, it is accentuated as computerized and high-frequency trading kick in and short-term momentum traders go along for the ride.

We'll see if any pockets of momentum develop that allow individual stock picking, but I'm not optimistic. Stay focused on the big picture and manage individual trades tightly. The easiest thing to do is let gains slip away when the market reverses sharply.

I'm inclined to look for some index shorts as market players debate the effectiveness of short-selling bans. The evidence is clear that they do not work well and that will eventually result in renewed market pressure.

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