May 13th, 2023: The self-fulfilling market: How short selling is impacting bank stocksLast week, the Federal Reserve announced another .25% increase to a target rate between 5.00%-5.25%. This is the last time I believe that the Fed will raise interest rates. The next move will likely be a cut. This week, the two key inflation readings came in lower than expected. Consumer prices in April showed a mild slowdown, with a 4.9% year-over-year increase. This marked the tenth consecutive month of declining annual inflation since peaking in June 2022. Unfortunately, for more conservative investors, the current risk-free rate of 5% will likely drop later this year and into next. These 5% rates are great while they last.
In the meantime, the high interest rates are continuing to wreak havoc on the banking sector. PacWest looks to be the next bank taken over by regulators. PacWest deposits fell 9.5%, or $1.5 billion. The drop came following reports that it was exploring options to bolster its finances. The good news is that the bank for now still has liquidity, and the survival of the bank will depend on whether more deposits leave the bank or not.
The banking crisis would be over instantaneously if the Fed lowered interest rates and the regulators limited shorting in regional bank stocks. Lower interest rates would slow the outflow of deposits, and making shorting more difficult would end the relentless selling of stocks. The set up here is this could become a generational type of buying opportunity if a number of things play out. There is already a number of very well capitalized regional banks with dividend rates of over 6% and only paying out 65% of earnings. The risk is mainly the short sellers.
I believe that the shorting of financial stocks is causing all this volatility. Short selling, or “shorting,” is when an investor borrows shares of a stock and sells them, betting the price will fall. When the price drops, they buy the shares back at a lower price. Next, they return the borrowed shares and profit from the difference. This can cause a stock’s price to fall because it increases the supply of shares in the market. As more shares are sold (even borrowed ones), the stock’s price can drop due to the imbalance between supply and demand. Additionally, heavy shorting can create negative sentiment around a stock, causing other investors to sell, further driving down the price. The rallying cry for the short sellers is that many commercial loans will default if the economy slows. While this is likely the case, a quick cure to this problem would be lowering interest rates. This could happen overnight with a 1% cut in rates.
Recently, Bruce Van Saun, CEO of Citizens Bank, provided a real-world example of how short selling could potentially destabilize a financially sound bank. He explained that short sellers could target a bank’s stock, precipitating a decline in the stock price by selling borrowed shares into an already descending market. This action could create an illusion of vulnerability around the bank. This would incite fear among its customers. The fear might trigger a withdrawal of deposits, mimicking the signs of a bank in distress. Subsequently, this panic could lead to a further decline in the stock price as more investors, unable to bear further losses, sell their shares. This cycle would cause more withdrawals. This would complete a self-fulfilling prophecy which benefits the short sellers at the expense of a perfectly healthy bank, its employees, and shareholders.
In times of heavy market swings, regulators have been known to put the brakes on short selling. For example, in the 2008 financial crisis authorities in countries like the United States, the United Kingdom, and Australia rolled out temporary bans on short selling for financial stocks. This is something they generally save for extreme circumstances when they need to keep the financial markets stable and trustworthy. Nowadays, they could go about limiting short selling by hiking up the borrowing rates on those shares. Even just the mention of a potential limited ban could be enough to halt coordinated short selling attacks.
In the next few months, we will continue to deal with rampant short selling and debates over the debt ceiling. All of these are putting a serious strain on our financial system and threatening to put the brakes on the economy. The government and the Federal Reserve have their work cut out for them as they try to navigate and mitigate these self-fulfilling prophecies. With some well-placed agreements, they could bring about a far more stable market. But until that happens, we can expect to see the markets continue their daily rollercoaster ride, responding to every twist and turn in the road towards these solutions. So, while it’s a challenging landscape, there’s still the potential for positive change if the right actions are taken. If not, there is going to be a short-term set up that could open up some very interesting opportunities in the banking sector.
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Last week, the Federal Reserve announced another .25% increase to a target rate between 5.00%-5.25%. This is the last time I believe that the Fed will raise interest rates. The next move will likely be a cut. This week, the two key inflation readings came in lower than expected. Consumer prices in April showed a mild slowdown, with a 4.9% year-over-year increase. This marked the tenth consecutive month of declining annual inflation since peaking in June 2022. Unfortunately, for more conservative investors, the current risk-free rate of 5% will likely drop later this year and into next. These 5% rates are great while they last.
In the meantime, the high interest rates are continuing to wreak havoc on the banking sector. PacWest looks to be the next bank taken over by regulators. PacWest deposits fell 9.5%, or $1.5 billion. The drop came following reports that it was exploring options to bolster its finances. The good news is that the bank for now still has liquidity, and the survival of the bank will depend on whether more deposits leave the bank or not.
The banking crisis would be over instantaneously if the Fed lowered interest rates and the regulators limited shorting in regional bank stocks. Lower interest rates would slow the outflow of deposits, and making shorting more difficult would end the relentless selling of stocks. The set up here is this could become a generational type of buying opportunity if a number of things play out. There is already a number of very well capitalized regional banks with dividend rates of over 6% and only paying out 65% of earnings. The risk is mainly the short sellers.
I believe that the shorting of financial stocks is causing all this volatility. Short selling, or “shorting,” is when an investor borrows shares of a stock and sells them, betting the price will fall. When the price drops, they buy the shares back at a lower price. Next, they return the borrowed shares and profit from the difference. This can cause a stock’s price to fall because it increases the supply of shares in the market. As more shares are sold (even borrowed ones), the stock’s price can drop due to the imbalance between supply and demand. Additionally, heavy shorting can create negative sentiment around a stock, causing other investors to sell, further driving down the price. The rallying cry for the short sellers is that many commercial loans will default if the economy slows. While this is likely the case, a quick cure to this problem would be lowering interest rates. This could happen overnight with a 1% cut in rates.
Recently, Bruce Van Saun, CEO of Citizens Bank, provided a real-world example of how short selling could potentially destabilize a financially sound bank. He explained that short sellers could target a bank’s stock, precipitating a decline in the stock price by selling borrowed shares into an already descending market. This action could create an illusion of vulnerability around the bank. This would incite fear among its customers. The fear might trigger a withdrawal of deposits, mimicking the signs of a bank in distress. Subsequently, this panic could lead to a further decline in the stock price as more investors, unable to bear further losses, sell their shares. This cycle would cause more withdrawals. This would complete a self-fulfilling prophecy which benefits the short sellers at the expense of a perfectly healthy bank, its employees, and shareholders.
In times of heavy market swings, regulators have been known to put the brakes on short selling. For example, in the 2008 financial crisis authorities in countries like the United States, the United Kingdom, and Australia rolled out temporary bans on short selling for financial stocks. This is something they generally save for extreme circumstances when they need to keep the financial markets stable and trustworthy. Nowadays, they could go about limiting short selling by hiking up the borrowing rates on those shares. Even just the mention of a potential limited ban could be enough to halt coordinated short selling attacks.
In the next few months, we will continue to deal with rampant short selling and debates over the debt ceiling. All of these are putting a serious strain on our financial system and threatening to put the brakes on the economy. The government and the Federal Reserve have their work cut out for them as they try to navigate and mitigate these self-fulfilling prophecies. With some well-placed agreements, they could bring about a far more stable market. But until that happens, we can expect to see the markets continue their daily rollercoaster ride, responding to every twist and turn in the road towards these solutions. So, while it’s a challenging landscape, there’s still the potential for positive change if the right actions are taken. If not, there is going to be a short-term set up that could open up some very interesting opportunities in the banking sector.