Selling America short is risky: Larry Black reports on the background to an unexpected rally on Wall Street that began by mistake

MANY on Main Street regard making money by betting on hard times as almost un-American, even if Wall Street's apparent morbidity is understandable.

Since 4 February, when the Federal Reserve began trying to slow down the recovery in the US, good economic news has been taken to mean inflationary dangers. In the end, economists warn us, we all pay for the high inflation that comes with too much good news, so perhaps those who have been relishing this summer's doldrums have been doing us all a favour.

Still, there are more than a few people on Wall Street taking pleasure in the recent rout of the most jaded of the market's prophets of doom, the traders who have been 'shorting' the shares of America's biggest industrial conglomerates in record numbers. The stock- market slump that has accompanied the Fed's tightening had encouraged them to bet on the decline of some 1.62 billion shares, pre-selling at prices below their current trading level.

But last week's 125-point jump in the Dow Jones Industrial Average left them badly squeezed, scrambling to buy the shares they needed to complete their sales, and paying a premium for them. That the stampede into big Dow Jones cyclical issues was the result of a failed ploy by one of their number makes their undoing all the more satisfying, critics say.

While conditions for a recovery - a rise in mutual fund contributions, good earnings, year-end desperation among portfolio managers - have been assembling for several weeks, and some respected forecasters have turned bullish, it seems the market needed a push. The impetus apparently came last Wednesday, when a lone options trader, William Mullen of Washington-based Loomis, Sayles and Company, tried unsuccessfully to unwind a sophisticated hedging arrangement that was predicated on a decline in an index, the Amex Institutional, tied to 75 blue-chip American corporations, including General Motors, AT&T and General Electric.

Instead of making a small profit betting on the market's sluggishness, however, Mr Mullen's strategy backfired, losing his firm less than dollars 1m but provoking the strongest market surge in 19 months. An investigation of the day's events, initiated by the New York Times and advanced last weekend by Barron's, the investment weekly, provides an amusing cautionary tale about the dangers of 'selling America short'.

Mr Mullen's trading strategy involves a derivative product called a 'flex option', and what is important to know about them is that unlike normal options, which come due on the third Friday of every month, flex options can expire on any pre-arranged date - in this case, last Wednesday. So when Mr Mullen's counter-parties moved suddenly in the final minutes of last Wednesday's session to buy dollars 100m worth of the shares that underlie the Amex Institutional index, Wall Street's other short- sellers panicked. This wasn't a 'witching day', as expiration Fridays are known, so they assumed they were encountering a wave of institutional buying.

Loomis, Sayles's counter-parties had apparently sold the shares short to hedge their minor bullish bet with Mr Mullen - that the Amex Institutional Index would close above 468. But Wednesday was turning out to be one of the few good days cyclical shares have had this summer, and by the end of the day, it was clear that their 'call' options were not going to expire worthless - allowing Mr Mullen to pocket the fee - but were in fact going to close 'in the money'.

'Then they got greedy,' as one analyst put it, abandoning their hedge by deciding to buy the shares they had shorted, entering an estimated dollars 200m worth of 'market at close' orders for that amount. By 3:59pm on Wednesday the Dow Jones Average was up 53; a minute later it closed up almost 71.

The surge was strong enough - a gain of almost 2 per cent in the Dow - to be self-sustaining. After retreating slightly on Thursday, the market rushed ahead on Friday and improved again yesterday.

'The shorts have been squeezed dry of even a soupcon of juice,' said Barron's veteran columnist, Alan Abelson - who has himself been accused of colluding with them in the interest of a good story. 'They have pretty much been reduced to a mess of very ugly pulp.'

Rallies fuelled by short-covering alone tend to be short-lived. But the consensus on Wall Street is that this rally will endure, at least until this weekend's Labor Day holiday in the US. The Dow, which had gained only 127 points so far this year - 125 of them last week - will see 4,000 yet this year, argue the portfolio managers, who seem desperate to salvage a bleak year.

And contrarians could be in for more trouble ahead, warns Biddle Washington, a trader on the American exchange: 7,000 more flex options are set to expire on various days between now and Christmas: they would be well advised to mark 21 September, 26 October and 21 December in their calendars now.

(Photograph omitted)