Wednesday December 9 8:22 AM ET
Falling into the short-sellers trap
By Christopher Byron
Have you been watching in baffled amazement - day after day and week after week - as the entire market seems to turn around in the last hour of trading and erupt in a frenzy of buying, with the
Internet stocks leading the day?
For the big cap stocks, the favored explanation for these abrupt reversals and seemingly random spurts, often boils down to so-called program trading.
But for the thinly traded stocks of the Internet sector, it's not program trading at all that's at work. Instead, it's naked short-selling by investors who rightly see that the sector is over-priced, but are simply aggravating the situation - while costing themselves dearly in the process - by putting on
positions that can't close out.
For a classic text-book case on how this works look at the recent trading history in Navarre Corp., a Minnesota music and software wholesaling company.
The company has balance sheet cash of only $19,000, with ballooning account receivables that
equal 66 percent of total assets, a six-week inventory of merchandise that is costly to finance yet
could become obsolete and worthless at any minute, deepening losses on shrinking revenues that are
currently running at $200 million annually, with total balance sheet equity of only $23.4 million, and
that is burning through its cash at a rate of $50 million a year.
Oh yes, and let's throw in one other thing. Only a month ago the company was selling for a mere $3
per share yet today is selling for 4.5 times that much, giving the business a market value of $147.6
million on Wall Street whereas it was worth less than $50 million just a few weeks earlier.
Given all that, wouldn't you want to reach for the phone, call up your broker, and say, "Boy, have I
got a stock for you to short!?
Sounds like a no-lose proposition, to be sure. But plenty of otherwise smart investors had their
heads handed to them Monday on just that idea. They tried to "short" a deeply troubled - and wildly
over-priced - stock and wound up causing the stock's already-overheated price to rise even further.
When trading in NASDAQ stocks finally ended, Navarre had racked up the biggest percentage gain
of the day on any major exchange - a nearly 70 percent price explosion in the face of broad market
averages that barely budged at all.
What happened? Navarre is a wholesaler to the consumer market - a difficult, low-margin business
in the best of times. But Navarre is especially vulnerable thanks to its dependence on the
unpredictable contemporary music scene. It has thus thrown resources into its CD-ROM business,
but the margins there aren't great either.
As a result - and mainly it would seem to shed a money- losing business at what it hopes will be a
sky-high price - the company has lately been hinting that it is planning an IPO spin-off of a division it
had acquired the previous year to provide radio programming over the Internet. The business has
never made a dime for Navarre, and the company has cautioned investors in government filings that
the business may never turn a profit either.
But in the frenzied state of the Internet market, such warnings are quickly discounted by investors,
who think the stock will rise simply on the basis of its connection to the Internet. So they buy it, and
the price does rise - though common sense says that if the business were actually worth something as
a business, Navarre wouldn't be selling it in the first place.
In this situation - and many other like it as well - the would-be short-sellers have been making a
classic mistake: they've been attempting to cash in on the company's over-heated share price by
"naked short-selling." That is, they've been selling shares they haven't actually been able to acquire
later on in case rising demand made "covering" the short positions necessary.
The tell-tale clue in the case of Navarre on Monday? As a hedge fund manager in San Francisco
explained to me, the approach of the end of trading on Monday caused back-office clerks in
brokerage firms all over Wall Street to begin the routine process of exercising forced "buy-ins" to
close out uncovered short positions in accounts which shares had been promised for delivery but
hadn't actually been delivered.
By the dynamics of the market, this process caused Navarre's price - which had opened strong but
had held fairly stable thereafter for most of the day - to begin to rise strongly in the final hour of
trading. This in turn encouraged day traders and momentum hedge fund operators everywhere to pile
into the stock. Result? Nearly a third of the stock's total trading volume of 13 million shares for the
day took place in the final 60 minutes, and Navarre ended the session with powerful upward
momentum.
Does this sort of thing seem familiar to you?
"This is going on constantly," says my source. "These guys are just walking into the same trap day
after day, and it's causing the entire sector to shoot into orbit. It's not just individual stocks but an
entire sector of the stock market that's now caught in a short squeeze. If you're 'long' these stocks
it's the payday of a lifetime. If you're short it's a calamity."
My friend says this will all end soon enough, and that in the end, pricing stability will prevail -
because, in the end, it always does. But, he says, anyone trying to short these stocks now is just
asking for trouble.
As I wrote in this space not long ago, we've entered the final phase of extreme excess in the current
bull market. But that phase isn't ending yet-in fact it may only be just beginning. Meanwhile, if an
Internet stock is over-priced, don't think you're looking at an invitation for a short-sale. You're
probably just looking at a "sucker's short" instead.
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