SEC Induced Rally In Financials?

There was a nice, shall we say really nice rally in the financial stocks yesterday, with the XLF surging up 12%. Fannie and Freddie also had big days. Down volume in the XLF has also recently spiked to record levels (twice), potentially indicating capitulation (see a nice article by Bill Luby at greenfaucet.com). Yet, I have to wonder how much of Wednesday's movement is based on the recent SEC changes in the short selling of financial companies, and how much is due to capitulation and a potential market bottom. Have all the problems with Fannie, Freddie, banking, housing, and credit been cured since we can no longer short without (heaven forbid) actually borrowing the shares we want to sell?

A WSJ article discusses the changes in the short selling requirements. In short, the SEC has created a temporary protected list of 19 financial companies that prevents naked short selling of their shares. The extra protection of the 19 companies will continue until July 29, but can be extend for 30 days beyond the original July 15 date, and could be extended to more companies. Now, instead of allowing brokers to sell a stock short as long as they have a "reasonable" belief they can locate the needed shares and actually deliver them, they will now need to make formal arrangements to borrow the shares before shorting. The new rules will prevent multiple brokerage firms from looking at the same available stocks from the same custodial banks, assuming they would be able to deliver these shares if necessary. While the stock prices of the listed companies reacted positively to the added restrictions, it is unclear that the companies themselves will appreciate the added stigma of appearing to need government and SEC protection. The effects of the new shorting rules on hedge funds - who actively engage in short selling - is also unclear, but certainly not positive as each will now need to secure shares first before shorting. Hedge funds do have the ability to use puts and swaps, yet those on the other side of these derivative trades may need to find other ways to hedge their exposure.

But is this the real problem, and will the current SEC changes really fix the underlying issues in the market? It is mentioned that short interest has risen sharply for financial stocks and the NYSE and Nasdaq markets since the last market correction eight years ago. But is this really any surprise? Financials have been one of the largest, if not the largest sectors in the market. Given that they are now suspect due to the recent credit and housing issues, and have been for some time, would you not expect both the financials and the market to see increased levels of shorting?

The recently increase in down volume experienced late last week and early this week may be the capitulation that the market is looking for. Regardless of whether it is or not, I am still not convinced that an SEC induced short sale restricted rally is the making of a recovery. If it is, what does this really say about our markets?