Financials Rally…Are the shorts being squeezed?

Wells Fargo beat street estimates on their earnings announcement leading to a huge rally in financial stocks.  US financials were up somewhere between 10% – 20% at midday. The average investor is probably asking how the earnings of one company can lead to these types of gains for a whole sector in just one day.

While Wells Fargo had something to do with todays gains, there is probably another large factor at play today. Some financials have been beaten down to the tune of 90% – 95%  of their 52 week highs. Do they deserve to lose all of their value? Perhaps. What I do know is that most hedge funds have made alot of their money in the last year shorting financial stocks and reaping the gains as their prices continued to fall.

What is scaring the short sellers is an announcement by the SEC that would make the naked short selling of Fannie Mae and Freddie Mac illegal. Short selling entails borrowing stock that you sell today with the hope that the stock drops later on at which point you buy it back at a lower price and pocket the difference.

With naked short selling, there are no shares being borrowed which can lead to much lower share prices than normal as there can be more shares being shorted than shares actually issued by the corporation.

The announcement yesterday by the SEC is probably leading some short sellers to cover their positions as naked short selling is illegal regardless of the stock and the announcement is giving short sellers warning that the SEC is going to enforce laws already in place.

The other aspect to this which can be read in many other commentaries today relates to something called “The Uptick Rule”. This rule was removed not long ago which basically only allowed a short sale to take place on a stock after the stock ticked up in price. This rule once removed has allowed short sellers to drive a stock lower with abandon. Discussion is taking place to re-implement the uptick rule which should shore up stock prices as well.

What are your thoughts? Do you think financial have hit bottom or is this just a short term rebound?

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