The “Junk” Rally

I have warned readers for a few months now that we are living in a government debt bubble economy and are heading for the second drop in a double dip.  Some analysts are discovering that the market’s rally is built on nothing more than speculation and gaming.  The market is actually being driven by short sellers.

A short seller is someone who borrows shares of a stock, sells them at a high price, and then buys them back at lower prices to return to their brokers.  Many times this actually drives the stock prices down.  Short selling was blamed for the initial market plunges a couple years ago.   AP Business Writer Bernard Condon explains that in this case we are in a “short squeeze” which is driving prices up.

Ok, time for some layman terms:

To explain it more simply, short selling would be like this.  On January 1st of this year, you pay your friend $100 to borrow his brand new Toyota with only 5,000 miles on it.  You then sell that Toyota for $17,000.  February 4th, that same model of Toyota has been recalled and has dropped in value.  You buy the same model with 5,000 miles on it for $15,000 and return it to your friend.  You made $2,000 on the deal and your friend made $100 bucks for lending you a vehicle in the exact same shape as the one he got back a month later.  That is essentially a short sale.

A short squeeze is a little more complicated.  Imagine you borrow 100 Toyotas from your friend and sell them all for $17,000 a piece.  That model is recalled and drops in value.  However, as you expect the price to drop further and hold off on repurchasing, the government institutes cash for clunkers and car buyers are happy to take their chances on a Toyota for $2,000 less than the usual asking price.  The value goes back up.

Now it’s March and your friend wants the next month’s payment.  He also sees that the value hasn’t gone down and wants to make sure you can repay him.   He says that if the price continues to go higher you will need to reduce the number of outstanding Toyotas you have borrowed from him.  As a result, you are now buying them back for more than you sold them for.  Your purchases to cover your loan drive the overall price up even higher.  This is the short squeeze.

The result is that worthless stocks are being driven higher in price as short sellers buy even more worthless stocks to cover their loans.  The result, as Condon points out, is that companies who haven’t made a profit in years are seeing their stocks quintuple as bargain hunters buy cheap and short sellers are forced to then buy back high.

Eventually we will run out of short sellers who sold too low.  When we run out of short sellers who sold too low, and the bargain hunters start to see a drop off in price gains, we will see a new round of short sellers who will be as deadly effective as the 2007 short sellers in driving the price down.

This coming market correction, mixed with the stimulus money running out, the deficit completely overwhelming us, and the coming tax increases in Obama’s budget will put us into a full blown depression in less than a year.  We need a new economic course.  Hopefully November will bring some fresh ideas to Washington.

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