On September 19 a host of countries, including some emerging markets, banned short selling financial stocks and, in some cases, banned short selling altogether.

The United States Securities and Exchange Commission (SEC) banned shorting 799 financial companies until October 2 hoping to stem the market crisis unleashed upon financial stocks. On September 22, the SEC added another 30 names to the list, including General Electric and General Motors -- also threatened by the rising cost of borrowing and declining share prices.

The United Kingdom’s FSA or Financial Services Authority also joined the SEC last Friday followed on Monday by the Netherlands, France, Belgium, Germany, Taiwan and other countries. This marks the second time since July that the SEC has imposed a temporary ban on shorting financial shares.

This legislation won’t help the markets and ultimately will create a new round of broad-based selling when trading bans are finally lifted. Also, bank stocks have possibly bottomed for this cycle as evidenced by a slew of financial indices – all comfortably above their lows set in mid-July.

Since the last SEC trading ban expired, two Wall Street behemoths, Lehman Brothers Holdings and Merrill Lynch, have either collapsed or merged with other companies. The first ban in July did nothing to help these fractured financial services companies.

In Truth we Short

Short selling, or borrowing shares in anticipation of future price declines and purchasing those same shares later, hopefully at a profit, creates truth in an otherwise corrupt marketplace where some companies dodge accounting rules and fudge their books to hide losses. The latest salvo fired at short sellers this month targets the wrong group of traders, who, in fact, help to create liquidity in the markets and stem market bubbles. Short sellers try to honestly target aggressive accounting practices and, more often than not, help to create a balance in an otherwise heavily manipulated market that is aggressively geared towards sell-side practices.

Short sellers are also racking up the best returns in 2008 among diversified hedge fund strategies. According to the Credit Suisse Tremont Dedicated Short Bias Index, short sellers have gained more than 10% this year through August and up 12.5% over the last 12 months while traditional equity benchmarks have crashed by about a quarter. In September, estimates point to another 5% gain for this group.

One of the more respected short selling specialist firms, Kynikos Associates in the United States, was one of the first firms to isolate questionable accounting at Enron; that company, along with several others, including Worldcom and Tyco, eventually went bust following suspicious accounting practices and fraudulent management. Company CEOs were either prosecuted or heavily fined and will never be allowed to manage a public company again.

By targeting and banning short sellers, the SEC is barking up the wrong tree and removing one of the last market based sanctuaries in a dreadful year for financial assets.

SEC Gets Failing Grade

SEC Chairman Christopher Cox has finally awoken from a deep sleep the last 13 months. Presidential candidate, John McCain, publicly denounced Cox last week, claiming the first thing he would do if elected this fall is fire Chris Cox. I agree.

The SEC has literally been asleep at the wheel until July, doing absolutely nothing to police aggressive accounting by financial company CEOs and did nothing to warn investors about suspicious accounting, aggressive sales practices involving mortgage-backed securities or the bubble that inflated among mortgage offerings.

Other high-risk securities, including collateralized debt obligations (CDOs), credit default swaps (CDSs) and other credit derivatives that are now endangering the global financial system are not even regulated yet alone scrutinized by the SEC. What was the SEC doing all this time as financial markets were haemorrhaging?

Instead of doing its job ensuring that U.S. capital markets are properly regulated, the SEC is now pointing fingers at short sellers and blaming this highly skilled group of traders and analysts for the markets’ crash earlier last week. Yet Cox, in a public statement earlier in his tenure claimed “We need the shorts in the market for balance so we don’t have bubbles.”

The Big Short Squeeze

It’s not the first time a country has banned short selling.

Recently in June, 2007, Pakistan banned short selling practices; fifteen months later the market in Karachi is down by another third. England also banned short selling in the 17th century following the collapse of the Dutch tulip mania. That effort also failed to calm the markets.

The SEC’s ban on financial stock short selling is primarily why global stocks posted huge gains last Thursday and Friday. Short sellers scrambled to cover their bearish bets or were forced to buy back the same stocks they were betting would continue declining.

This classic “short squeeze” won’t help alleviate market sentiment and points blame to the wrong segment of the market. If a company or sector should be valued at a lower multiple then government intervention in a free market is the wrong policy response; this action will only delay another day of reckoning as banks face mounting losses on traditional lending practices, including credit cards, auto loans and other facets of lending.

Shorting is American as Apple Pie

By banning short selling the government is effectively saying that it’s trying to determine where stock prices should settle. That’s not what a free market is about. This response damages the credibility of the free market system and ultimately suppresses the true value of an entity.

If the SEC and other governments can ban short selling, then one has to wonder which segment of the market is next to face regulation or restrictions?

Is Gold Next?

In 1933, under Executive Order 6102, FDR confiscated gold ownership. Under extreme market circumstances governments can impose extraordinary measures that usually do not benefit the poor, unsuspecting investor. The current financial crisis in the United States is the worst since the Great Depression and might warrant other measures that confiscate foreign currencies, precious metals or other international assets and securities. Anything is possible.

As this crisis eventually fades or possibly gets worse, investors should use the offshore private bank account window before it closes. It’s still legal to move money to Europe. The best destinations for asset protection remain Switzerland, Liechtenstein and Austria. Having some gold stored in these European countries is a powerful safe-haven strategy amid extreme economic circumstances and, at least, provides the investor with a high margin of safety ahead of the next financial debacle.