A painful squeeze on short sellers

Volkswagen was briefly the most valuable company in the world this week because short sellers made the wrong bet. It's another sign of a volatile market.

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By Paul R. La Monica, CNNMoney.com editor at large

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NEW YORK (CNNMoney.com) -- Still looking for a last-minute Halloween costume to scare those trick-or-treaters knocking on your door? Just put on a suit and tie and start bashing bank stocks. Eek! A short seller!

Short sellers, investors who bet that stocks will go down, have been demonized - often unfairly - during this market meltdown.

In an attempt to stem the bearish tide washing over Wall Street, the SEC even took the creative, and I think misguided, step to temporarily ban the short selling of financial stocks last month.

So if you are one of the many people who think that short sellers are the financial equivalent of those handlebar mustachioed villains tying damsels to railroad tracks in silent films, this column's for you. I'm going to take a look at what can happen when the shorts are wrong and things go horribly awry.

Short sellers borrow stock and then sell it with the hopes of buying it back later a lower price so they can pocket the difference. But they don't have forever to sit and wait for the stock to fall before they must return the shares, or cover their position.

When a heavily shorted stock begins to rise for some reason, such as unexpected good news, short sellers often quickly rush to buy back the stock because the higher the stock goes, the bigger their losses would be. This is known as a short squeeze and it has happened several times in the past week.

The most notable example is what took place with shares of German automaker Volkswagen on the Frankfurt Stock Exchange.

The stock more than doubled on Monday and nearly doubled again on Tuesday. At one point Tuesday, the company briefly topped Exxon Mobil (XOM, Fortune 500) as the world's largest company by market value.

What gives? Investors didn't suddenly come to a realization that the business of making cars isn't that bad after all. A quick look at the stock prices of GM (GM, Fortune 500) and Ford (F, Fortune 500) tells you that.

But what happened was that German carmaker Porsche, which already owned a big stake in Volkswagen, issued a surprise announcement on Sunday saying that it intended to boost its stake even more.

So investors that were making the reasonable bet that Volkswagen's stock could continue to fall along with other global automakers were suddenly faced with a need to buy the stock.

And that fed on itself. The frenzy was compounded by the fact that there weren't that many available shares left to buy since most of the stock is already owned by Porsche and the government of Lower Saxony, the state in Germany where Volkswagen is based.

The squeeze in Volkswagen was so dramatic that it even led to some rumors, which turned out to be unfounded, that investment banks Goldman Sachs (GS, Fortune 500) and Morgan Stanley (MS, Fortune 500) were facing steep losses because of short positions in Volkswagen.

This was the most prominent case of a short squeeze this week but there were others. Shares of casino operator Las Vegas Sands (LVS) surged 80% Wednesday after rival MGM Mirage (MGM, Fortune 500) reported that its hotels in Las Vegas were still nearly full despite the economic slowdown and that the company was also on track to receive more funding for a new project in Sin City.

That was viewed as a positive sign for all casino operators. But Las Vegas Sands probably shot up the most since short sellers were making big bets on the stock. As of mid-October, more than 15% of the company's available shares were held by short sellers, according to Shortsqueeze.com, a research site that tracks short selling.

And a less dramatic squeeze appeared to take place this week with online jewelry retailer Blue Nile (NILE). The stock rose nearly 15% on Wednesday after American Technology Research analyst Tim Boyd upgraded the stock from "sell" to "neutral."

In his research report, Boyd cited the possibility of an even bigger pop ahead if the company reports better than expected earnings or guidance or other good news. That's because more than 46% of the company's shares were being held short as of mid-October, which Boyd described as "an abnormally large amount of squeeze fuel."

Now what does this all mean for the average investor? For one, it shows that short sellers aren't perfect. They often do a great job of identifying overvalued companies that are ripe to take a beating. But they make mistakes, particularly with timing.

And that point is crucial. Short sellers, by their very nature, can't afford to make long-term bets. So even in the case of a stock that gets squeezed, that may not mean that the shorts were completely wrong about where a company may be heading.

For example, Volkswagen may still not be a great buy because of what's going on with the global economy. Ditto for Las Vegas Sands as people may pull back on vacations. And with many predicting a blue Christmas for retailers, it's hardly a slam dunk that Blue Nile will boost its outlook.

Add that up and that means that the short sellers may simply lick their wounds and then start short selling these and other stocks again.

"Being right and having the ability to stay right is limited. The shorts were eventually right about Lehman Brothers," said Doug MacKay, president and chief investment officer of Broadleaf Partners, a money management firm in Hudson, Ohio. He was, of course, referring to the investment bank that filed for bankruptcy in September.

And unfortunately, these squeezes are yet another sign of how tumultuous the markets have become.

Even though some hedge funds and other large investors may occasionally rush to buy a stock to cover a position, many are still in a mode where they are being forced to sell stocks as well.

So it's still tough to say with any confidence that the worst is over for the market. The pendulum is likely to continue swinging wildly in both directions and investors shouldn't get to enthused by big one-day moves in the overall market or specific stocks.

"Look, we know the economy is tough. But this selling is as much about margin calls and liquidity problems for investors. People are having to do things they may not want to do," said MacKay. "If you are already in the market, these short squeezes can help you understand why things are so volatile on a daily basis." To top of page

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