Last week I wrote a
piece about short-sellers' shenanigans. Like the Lucent piece two weeks ago, this article included a number of issues that newcomers did not understand. So, once again, I will annotate so that people just getting started or unfamiliar with the lingo will be able to get more comfortable with these kinds of terms. One quick note. Bill Fleckenstein, the admirable student of the short side, shot me an email this week reminding me that the longs have a big bag of tricks, too. Next week I intend to spend some time on those as Bill is dead right.
Did you ever wonder how stocks that close up (finish the day in positive territory) "look down" in pre-market trading? (As stock trading officially starts at 9:30 a.m., any trading of American stocks before that is called pre-market trading. The word "look" is a Wall Street term of art. It is short for an indication of what something is expected to do. In this case, "looking down" means that people involved in the stock expect it to sell off at the opening.) Does this paradox bother you (are you incensed as I am that stocks don't act rationally at the beginning of the day?)?
Maybe you should stop to think about the shenanigans that go on before the market opens, shenanigans meant deliberately to depress stocks with the hopes of creating a selling panic. That's what this piece is all about.
Take yesterday's trading in
(my favorite networking stock, or stock that provides sophisticated equipment that allows different computers to both be connected and make sense to each other. The data that appears on my quote screens are relayed by a Cisco server in my computer closet that is plugged into a phone line that is attached to the server at
, my quote provider.) The company reports a perfect number, a penny better than estimates. (On Wall Street companies generate consensus earnings estimates by using models that predict the number of goods sold, the cost of the selling, and other variables. Your hope is that the company you are following exceeds those numbers, showing that it is a head of plan. A penny seems like a silly amount, but that's because we are using pennies as computed in earnings per share. If we did not use EPS, this difference would amount to a huge amount of money, and is very important in determining the true health of the business). The conference call goes well. (Everytime Cisco reports its quarterly earnings, within 45 minutes its management hold a conference call -- always taped -- with analysts and shareholders where they detail the quarter. In the conference call you receive guidance about tone of business and how earnings estimates are shaping up for future quarters). Asia's bad, of course. (Cisco has substantial business exposure to Asian countries and these businesses have been slowed by the weakness in the area, but that should have been no revelation to those who have followed the company with a modicum of thought). But the book-to-bill is plus one, Wall Street shorthand for "the orders are robust." (We on the Street are always concerned that future prospects may not be as good as past results. One good way to measure it is to ask if there are more orders going in than going out. That's why the book-to-bill, or booked-to-billed, is so important.)
Analysts all reiterate their buys (We call this reit buy at our shop. When a company on a recommended list does what it is suppose to, the next day analysts who like the stock promote it through a concept known as reiteration of a buy recommendation. If an analyst does not reit buy, guys like me worry that a downgrade could be imminent. This reit buy notion is integral and often long side shareholders demand that sell-side analysts reit buys when stocks are sinking. Some do; others try to remain independent. I will pick up the phone and ask an analyst why he did not reit buy if a stock got hit because I don't want to be blindsided to important problems that a company may be facing that I don't know about.) Some people have to bump their estimates up; others keep their numbers the same. (This is a vital process. When a company reports a great number, analysts guide estimates higher. Much money in this country is run on a so-called earnings surprise model, meaning that if you only by stocks of companies that regularly get their estimates raised because of superior performance, you will make money. One of the reasons the whisper number concept developed is that if a company only met an estimate, instead of exceeding it -- hitting the whisper number -- there would be not earnings bump after the conference call and the stock would lose those champions who only buy when earnings estimate move up. Hence why this process requires such close bearing. Guys like Jeff, my partner, are always trying to caution me not to buy stocks that sell off because numbers weren't raised. I usually avoid them myself.)
The papers all read super (
The Wall Street Journal
plays a big role in this process. If their reporters talk to bearish analysts and get bearish comments, it will hurt the stock. As the
editors never ask their reporters whether the analysts either a. have done banking business and therefore may be compromised, or b. have a hold on it and are therefore more anxious in knocking the stock down, these stories almost always contain a degree of misinformation that is costly to the marketplace. It is a main reason why I set up
.) The tone of everybody involved is positive, if not loving -- including yours truly. (Cisco is a bit of a cult stock. It is so well-run and upbeat as to be a joy to own.)
And the stock is quoted down in Instinet in pre-market trading. Big down! (
has a machine that allows institutions to trade with each other. It shows bids (what people are willing to buy) and offers (what people are willing to sell.) It is like a giant auction bazaar. It operates all hours unless a specific stock is forbidden or halted from trading. In this case someone was offering Cisco down a full point from the last sale. That's huge considering many of us on the conference call expected the stock to go up.)
Beginning around 7 a.m. Wednesday morning the Instinet market -- an electronic trader-to-trader market -- showed Cisco down as much as $1 from the close. In other words you (meaning if you had an Instinet machine or if your broker had access to one) could buy Cisco at $62.5 "through the machine." (He can type an order in and take the stock that is visible there. First come first served.)
The fact that it was trading down a dollar already in the face of good news left many people who come in that early flummoxed. (Jeff and I talk to a tremendous number of people in the morning and everyone was buzzing about why Cisco might be down. As we are known as afficionados of the stock and we had no answers, we began to believe that the offerings were phony. But we could not prove it yet until we made more calls to be sure somebody found out something negative we did not know.) But not the press. (Pity the press; some hapless editor has to find a reporter to write a story about why Cisco is down. He calls his sources. Again: why did I want to start
? Because the reporters elsewhere are insensitive to the idea that the person on the other end of the line might want the stock to go down because he is short. That is why I never trust the press away from
with the exception of David Faber and Mark Haines as they are incredibly wise to these manipulations).
Reporters don't care if it is 1,000 shares of Cisco for sale or 100,000. They don't differentiate. All they need to know is that the stock is "trading down in pre-market trading." (This is the crux of this article. Sometimes real sellers know the news is bad and they want out ahead of a downgrade, or they have so much stock for sale they can't even wait for the market to open to start selling. But sometimes people want to color the stock trading by panicking people into believing that something is bad that is really good. This is Wall Street's version of disinformation, kind of a counterintelligence program if you will. How can the short-sellers do this, given that they are supposed to wait for an uptick, or until someone is willing to pay up before they can start leaning on a stock? Because in the Nasdaq there are no such uptick rules in before- or after-hours trading. With the last sale in Cisco at $63, you could offer stock short at $61 if you wanted to. No rules; Wild West. And believe me, it is effective.) They leaped on this artificial cumulus cloud in an otherwise sunny day (my six-year-old is learning about clouds, and at first I put in Nimbus but that made it look like a stock, and she corrected me when I used cirrus, which would also have been a stock!). Television talking heads, one after another, took time out to point to the decline in Cisco's shares despite the pristine quarter. (Very often the printed number, while looking good, may contain some false gain or one time gain that distorts the progress. At this moment we at our shop knew that it was a "clean" number, but we are not going to call Maria Bartiromo -- not that she would take our call, she's so big now -- and tell her it is a clean number, as we don't think it is our job to try to correct disinformation in the marketplace. It is our job to try to profit off short-term shenanigans that will eventually give way to the fundamentals.) Some even speculated that it might be a rough day for all stocks because of Cisco's early morning slide. (This would be true. Cisco is a true bellwether and any decline in the stock would spook people). All from a couple of thousand shares of stock offered down! (Traders always use terms like offered, rather than the awkward "trying to be sold down." You must familiarize yourself with concepts like bid side and offered side as these are integral terms at every brokerage firm.)
That's because a position as small as 3,000 or 4,000 shares offered below the last sale can create a powerful incentive to panic for many traders who don't know the ways of the shorts. (On Instinet you can see the size of the offering. Remember, we deal in large increments on Wall Street, and 3,000 is not large. But it might be a tell of something bigger coming and we will be fearful nonetheless.)
Not me. I knew those sellers were Wrong. (I am not Solomon or Einstein. But I know certain stocks. By 7:30 I was sure that anybody who was offering stock so low either thought the whole market was going down -- which I didn't -- or was just trying to manipulate the stock lower because every firm that mattered had told us that all was well and they found no flies on the Cisco quarter. That's Jeff's job and he does it better than anybody.) I have seen this game played so many times, the game where the shorts try to hose the longs by offering Cisco to make it appear as heavy as possible before the opening. (Short-sellers sometimes like to create an illusion of gloom by making a stock look heavy or well-offered. It is an illusion because unless there are hundreds of thousands of shares offered it is possible that someone is deploying a few thousand shares in the same way Stonewall Jackson deployed his troops, by just continually having a small contingent march back and forth to make it look like a large army.)
They offer it out loud. (Shorts as well as longs have friends. A short-seller can pick up the phone and tell a broker he may have a lot of stock for sale. He should disclose that it is short stock, but he may do that later, even though that is unethical as you should always declare right out front, as we do.) They offer it pathetically. (Sometimes the shorts put on an Olivier-like performance saying they are really worried and tell their brokers to look out, they may have to come out of a lot of Cisco. That's fire in a theater when someone has lit a match to light a cigarette.) They offer it solely with the hopes of catching a
on-camera reporter off guard so that the reporter might be suckered into digging up something negative about Cisco. (The reporter has to feed the beast; who can blame him for not being more cynical or skeptical?) That was the short-seller can bring in his shares that he sold short at a lower price than an honest market would let him. The profit is just much bigger. (Again, the crux of this piece. Short-sellers in this case bet wrongly that Cisco would have a bad quarter. Now they have no choice but to fight a rear-guard action to try to confuse the marketplace and bring out puking sellers that will allow the shorts to buy in their shares they sold. This is the equivalent of spreading the word that you saw Elway hurt right before the Super Bowl. Untrue, but it momentarily shifts the line.)
I know many of you are probably in utter disbelief that this stuff occurs (boy, judging from your email I was dead right about that), so let me walk you though the schematic of market manipulation by the bears (bears is Wall Street shorthand for people who bet against stocks to profit from their decline). Let's say the last sale for Cisco is at $63.5. (Cisco closed the previous session at 63 and a half). You go into the box or Instinet trading and you offer 1,500 shares at $62.5 (you have typed in an order that you would sell 1,500 shares at $62 and a half. It is anonymous.) For most Cisco players that's jarring in itself. (We would have expected the stock to be offered up one dollar, ex all of this manipulation). "I thought that was a good quarter" must go through hundreds of traders' minds when they see that offering. (Moves like this spread like wildfire from trading desk to portfolio manager and it is the rare portfolio manager who can go back to his trading desk and say, "disregard it." Most haven't done enough homework or are too underconfident.)
Remember, that offering is a point below the last price of the previous day at a time when people are expected the stock to open higher. (Unless some firm had downgraded the stock, when estimates are taken up after a quarter's announcement, a stock tends to trade up.)
But that's just part of the game. (I refer to game as the interplay between desperate shorts and overoptimistic longs.)
Usually some neophyte who does not know how rough the short game is played then takes those 1,500 shares at $62.5. (Lots of times people make mistakes in pre-market trading. They have inputed wrong, or heard wrong. We prowl this market all the time for people who make obvious mistakes. Total caveat emptor in their box. The buyer here probably thought that it might have been input error or an idiot offering stock.)
The short-seller is an expert angler. He then lays out another 2,000 shares of bait at $62.5 -- the same price. That spooks the neophyte a bit, but he's new at this fishing game and he bites again. He takes the stock. (I had just gotten back from some unrequited marlin fishing in the Atlantic and could not resist the analogy, sorry). The buyer figures the seller is just "off his market" and doesn't know he could get a better price if he just held out. (Here, remember, the buyer is still confident. He thinks the seller wasn't on the call or is trading from a phone booth in a cotton field in Lubbock. He had been prepared to pay up to the close of yesterday's trading because he liked the quarter. Right now he's thinking windfall because he has in his mind the idea of paying up for more stock.) The buyer thinks the seller is a moron. (Anyone with any confidence always believes that the guy on the other side of the trade knows less than he does.)
Now, the short-seller reels in the rookie buyer with a brazen act of mischief. As soon as the fish bites, the short-seller comes back and offers 2,000 shares of the stock at $62.25!! A quarter of a point below the #$^#^# last price paid. Holy cow, something must really be wrong! (This is the short-sellers' greatest gambit. It would be logical, considering that the buyer was willing to pay $62.5, that the seller would then play coy and go higher. I am sure the buyer in this situation expected the next offering to be at $62.625, an eighth above the last price offered, as the buyer was eager. But the seller's goal is to confuse the buyer, throw him off, and scare him, while everyone else is watching. By shrewdly offering lower than the last sale, the seller is sending the following message: I want out, I don't even care if you will pay me more. The Cisco situation is so bad that I will take less. That's a powerful negative statement.)
Unless you are a wily trader, you would positively want to puke up your 3,500 shares as soon as you saw that lower offering. (Traders constantly speak in terms of puking, because that means flipping stock you just bought at a lower price than you paid because you couldn't stomach it. Perfect image I must admit.) That's because anyone who doesn't know the tricks of the trade would have to presume that maybe Cisco is worse than anybody thought. Why else would a seller sell a stock BELOW where a buyer just paid? (There can always be doubts, worries that downgrade may be occurring. This kind of aggressive selling naturally precipitates a buy to hold recommendation as these things have a habit of leaking out.)
The faked-out buyer loses all of his confidence. He begins to think, hmmm, there must be a downgrade coming (that's the pulled buy recommendation fear) or a problem with the quarter that only this aggressive seller knows. (I can't tell you how many times I have beaten on Jeff when I see this pattern, screaming at him that something is wrong with his analysis, or you wouldn't have this torrent of selling.) It doesn't hurt to have a reporter commenting negatively about the stock price in the background. (The only obvious statement in this whole piece).
The neophyte then rushes to boot out his 4,000 shares of stock before the seller offers the shares even lower. (It is not uncommon that if that $62.25 stock isn't taken within 30 seconds, the seller will move to 62, to further confound and frighten the bulls.) Bids evaporate (buyers pull their indications of interest) and the stock begins to sink like a stone. In the meantime, the reporters get tipped off about the new negative Cisco activity, Cisco being the focus name for everybody on Wednesday, and start to gin up their negative theses to go along with the pre-market selling. (You know, they restate that Asia is a problem, and question whether the word had gotten out ahead of the quarter -- which is had many times.)
Soon, the reporters issue worrisome bulletins and those 4,000 shares sold short beget an avalanche as hundreds of others, watching this declining story unfolding on their machines -- the trading is visible to all with Instinet -- rush to beat out still more, bigger sellers that might be lurking. (Remember, we don't know if the action we have seen right now is an harbinger for giant sell-sized activity). Cisco becomes a down stock and the shorts use their chicanery to bring in their short-sales at much better prices than thought imaginable. (Remember, if all of this misdirection stuff doesn't get played, these shorts will have to buy in the stock at much higher prices turning gains into losses!)
That's where guys like me come in. I knew Cisco's quarter was a good one (homework, experience as edges). I know the tricks of the shorts (something that comes with 18 years of trading experience). I have puked out that phony 4,000 shares more times than I care to admit. (I have learned the hard way.)
But not this time. This time I just stood there. I bought all that the shorts could sell me. And then some. I bought at $62.75. And $62.5, each time carefully monitoring how the sellers would seek to sell stock below where I would pay. (As an old hand to this scam, I was determined to let these shorts lay on it and buy low and lower until I felt they had trapped themselves too low and then I would buy aggressively.)
And then I bought some more at $62. And then I paid up at $62.35. Two can play this game (Meaning I was now willing to pay above where the shorts were offering because I knew I had outflanked them.) And I paid up at $62.5, as the sellers grew nervous that the buyers weren't biting on this selling-induced panic. (In other words, I had taken the offensive and felt that the stock was so low that I wanted to get as much stock in at that level as I possibly could. I smelled a home run.) Because I know the game. Because I hate the game. (Given how hard it is to buy and sell, who needs these shorts playing this head game on the rest of us?)
Because I can make big money betting against these silly tricks of the trade that have no place in the market. (I don't think it is fair that short-sellers are allowed to offer stocks with no upticks in pre-market trading. It should be just like regular market trading. This rule should be changed.)
Sure enough, I amass a 25,000-share position with a $62.25 basis, or cost, in pre-market trading. And when all the shenanigans are done, where does the stock open up? At $63.5, because that's where the real, uncorrupt market was. (It was probably even higher if it weren't for all of the bogus attempts to fool buyers). That was the unmanipulated market. (This was a poor choice of words, because what the shorts did was perfectly legal; it was, however, unethical where I am from.)
All of that pre-market trading bore no resemblance to the real market, which was much higher than where I purchased all of that stock. It's nice to start the day with a gain.
Of course, without the chain reaction of panic, the short-sellers weren't able to bring their shorts in as they would have usually expected to. No wonder Cisco shot off like a rocket for the rest of the day. (Short-sellers who guessed wrong about this quarter and did not get a chance to cover because no short-selling panic ensued had to pay up in the fair market later on, no doubt inflicting much heavier losses than if their plan had succeeded.)
I am not Marshall Dillon. (Later on in an email, I said Quick Draw McGraw was more like it). Nor am I Robin Hood. I'm just a jaded sonofabitch trader who can spot when a con gets tired (this stuff has been going on for so long that I can't believe it is still tried!).
I'm sure the bad guys are cooking up new ways to trick me as I write this. Let's hope I am as ready as I was yesterday.
James J. Cramer is manager of a hedge fund and co-chairman of TheStreet.com. At the time of publication his fund is long Cisco and Lucent. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Mr. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he welcomes your feedback, emailed to