The Big Short Squeeze

Friday's markets had the desired effect of the New Government Plan. Global stocks soared to new heights as Mr. Paulson and Mr. Bernanke announced their new fund to help stabilize the credit markets. That plan will allow financial institutions to Dump soured assets into a new reservior of cash and most likely unlock the private sector's hoards of capital at private equity firms and hedge funds to compete in that bidding process. This will be very positive to ultimately clear out the bad assets but it does not address the Massive need to re-equitize corporate America. It also ignores the overleveraged United States Balance Sheet.

The positives of the plan were really Exaggerated by the Big Short Squeeze. Hedge funds and other investors, who manage balanced portfolios by shorting overvalued stocks, were penalized unfairly. Many of them rushed in to cover shorts on Friday which drove many stock prices to levels that don't necessarily represent the true value of the underlying companies. Investors who only buy stocks try to evaluate the fundamentals of the business and determine what fair value should be. If fair value is greater than the market value, investors in the aggregate will buy the stock. In the same vane, an investor who can short stocks, tries to determine fair value for an enterprise. If fair value is higher than the market capitalization of a stock, he may buy it. However, if fair value is lower than the market capitalization, he may short it (sell it).

Short selling is not the nemesis to the market. The short seller helps to balance the market by offsetting overly bullish long investors by allowing stock prices to move to their fair value. What we saw on Friday was not representative of a move to fair value in the market but a manipulation of prices such that stocks in the financial sector are now overvalued. Reality will set in as financial institutions need to writedown bad assets and raise equity capital to reduce the outlandish leverage that has built up over time. Stock prices for financial institutions will migrate, in time, to the levels that represent fair value. These prices will likely be at levels where short sellers accurately analyzed the true value of the companies.