Naked Before Byrne

Meanwhile, what little data are available suggest that naked shorting may indeed be out of control and that a much-ballyhooed trading rule known as Regulation SHO has so far done little to rein it in.

First, a little background. Shorting stocks, or selling shares you borrowed from another shareholder, isn't illegal. Abusive shorting, done to manipulate a stock price, is. And selling the stock of a badly managed company to a less-thoughtful investor is fair -- if brutal -- game in a market where stupidity is a sin. Over the past two decades, shorting has gone from a controversial strategy to an accepted practice that, nearly everyone agrees, weeds weak and fraudulent companies from the field.

More recently, the controversy has moved to naked short-selling. Naked shorting is in essence make-believe short-selling. In the same way kids play doctor without the medical equipment, naked shorters sell unborrowed stocks -- stocks that no one has borrowed and possibly never will. The SEC allows naked shorting in two cases: to maintain liquidity in hard-to-find shares and for anyone who shorted unborrowed shares before 2005. That second exemption has generated its own share of controversy.

As is often the case, stock newsletters were among the first to suspect a problem. The straw-man theory argues that critics of naked shorting are burned investors or corrupt executives who blame hedge funds the way failed businessmen blame the government for their own failures. But in recent months, newsletters like CrossCurrents and Biotech Monthly have sounded alarms on naked shorting.

"I'm quite confident that this is a much larger issue than anyone cares to consider," says CrossCurrents editor Alan Newman. It's hard to find bears any harder-core than Newman, who in February 2000 put a then-unthinkable 3000 target on Nasdaq and who today expects the Dow to sink to 8500. When the uber-bears are worried about the adverse impact of shorting, it's time to start worrying.