Patriotic Buying Is Unpatriotic

Play the market for what it is and, as a result, be better off and patriotic.
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Not long after two planes slamming into the World Trade Center crippled America's financial district and pushed the staggering domestic economy closer to recession, a horde of investors pledged via email to buy stocks to help prop up the market. It would be their patriotic duty, they said. Many responded -- but it didn't reverse the tide.

Indeed, the

Dow Jones Industrial Average plunged 14.3% this week, while the

Nasdaq fell 16%.

Take, for example, the wife of a

US Air

pilot who feared her husband might lose his job. She told her financial planner in Pittsburgh to invest $10,000 in U.S. stocks.

It may be hard not to expect some kind of altruistic behavior in the markets as many U.S. citizens give blood and volunteer their time to help the recovery process.

But the market doesn't work on ethics, or patriotism. In fact, it is unpatriotic to "buy patriot." No doubt most "patriotic buyers" this past week lost money. Trading against market flow most likely will do that. As a result, they have less money to spend in stores and to invest in the markets when sound buying opportunities do arise. Such a situation only hurts the U.S. economy -- rather than helps it.

In other words, financial professionals who advised their clients not to invest in a reeling market didn't choose their fiduciary duty over patriotism. To the contrary, it was their patriotic duty to tell their clients not to buy just for the sake of buying.

If any emotions can be applied to the buying and selling of stocks, it is fear and greed. If you want to be patriotic economically, spend money in Macys instead.

Investors need to play the market for what it is.

"People are emotional to a standpoint and then ultimately trade with pocket books," says Christopher Schumacher, CEO of GST Capital Group, an investment and trading services company. "Nobody is going into the market to lose money. There are so many other ways to show patriotism than losing money in the market."

Simply put, if investors took stakes in companies with shaky fundamentals, they lost money.

Even now, after this week's market plummet, buying still might not be a good idea. Valuations have decreased, but some stocks are still pricey. "We are talking about a wholesale lowering of earnings and multiples right now," says a Boston-based hedge fund manager. "We may not be able to argue valuation unless we see stocks come down to LBO

leveraged buyout levels."

Even Warren Buffett said he wouldn't buy unless the market dropped sharply, the hedge fund manager points out. "I spoke with mutual fund managers who said that it would be irresponsible of them if they didn't raise cash for redemptions," he adds.

Strategies for a Bear Market

But a certain kind of selling can produce returns. Short-selling, for example. In this practice, investors sell borrowed shares and buy them back later at lower prices. Such a strategy is used when investors believe a stock will go down. A put option is slightly less risky. It is a contract that gives a holder the right, not the obligation, to sell an asset at a specific price before a certain date. An investor loses money on put options when the underlying stock rises, rendering the option worthless. In that case, the only money the investor loses is the price of the option.

It is not surprising, then, that the recent bear market has attracted a slew of short-sellers. Indeed, the short interest on the

New York Stock Exchange and the Nasdaq has steadily increased during that past three months. As of mid-August, short interest in the NYSE reached a record 5,911,585,985 shares from 5,780,881,158 in July, while Nasdaq securities totaled 4,062,490,704 shares compared with 4,013,408,493 for the same month.

But, traditionally, people have considered short-selling unpatriotic simply because it is negative. Since the 1600s, in various countries during certain periods, short-selling has been banned.

In the wake of the much-publicized

Securities and Exchange Commission

investigation of an unusually high number of put options for the stocks of

AMR

(AMR)

and

UAL

(UAL) - Get Report

, the parent companies of American Airlines and United Airlines, which each had two planes hijacked during last week's attacks, the idea of short-selling has been considered even more unpatriotic. Government officials are trying to determine whether the terrorists tried to profit in the stock market.

Ironically, however, just like the patriotism of financial professionals advising investors not to buy stocks, short-selling is similarly patriotic. High short interest in a stock alerts investors that a company is struggling and most likely is not a good investment.

For a short-seller, the current market climate is ideal. It highlights less-healthy companies, which must resort to tricks, games and ploys to help them stay afloat. To be sure, short-sellers are now finding new names.

But in another ironic twist, short-sellers were actually among the few traders who propped up this week's market. Since an investor can short only a rising stock -- executing the sale on a trade higher than the previous one -- the free-falling market this week didn't give short-sellers much of a chance. Indeed, most short-sellers were net buyers this past week, covering their shorts. In this way, they bolstered the market.

"Short-selling,

in general, is necessary because it creates support when the market shows a bottom," explains Schumacher. "If there is no short interest, the market will not have the extra support of those covering their shorts, and it will fall faster. Short-selling keeps the market stable during times of mass selling."

Because of the complexity and risks of short-selling, however, individual investors would do better to use the increase in short interest of certain securities as indicators not to buy long, rather than as a chance to short sell.

Lee Barney and Scott Moritz contributed to this report.