WIth the market tanking, short sellers have become a popular scapegoat. Some observers whine about naked short selling while others lament the end to the uptick rule, suggesting that that has been a driving force behind the market turmoil.

Vanguard Group founder John Bogle, one of the few heroes in a financial services industry filled with villains, has a letter in today's Wall Street Journal explaining why the "blame the shorts!" explanation is wrong. He states it simply:

The uptick rule will not prevent price declines or bear raids. These events can and will continue to occur when security prices are too high compared with a company's earning prospects and risk.

Exactly!

The reality is that bubbles in equities form, and policies that make short-selling more difficult allow markets to overheat and inflate. Now that the party is over, angry investors are lashing out at short sellers.

Big investors who make money by selling stock short have enjoyed a money-making paradise. The Wall Street Journal provided a valuable public service by investigating how they made money shorting Morgan Stanley (NYSE: MS), helping its stock plunge in mid-September.

Conceptually, what shorts did was very simple -- they shorted the stock then they bought thinly-traded Credit Default Swaps (CDSs) on the bonds of the stock they wanted to short. (The Journal quotes Erik Sirri, a Babson Finance professor now working at the SEC whose office is next to mine, on the ease of manipulating CDS premiums.) This forces up the premiums and scares investors. The short sellers, in many cases, also withdraw their considerable funds from the targets' prime brokerage accounts; when asked why, they say that the firm in question is going bankrupt.

Needless to say, these rumors get spread around trading desks. Whether or not they're true, many investors are inclined to withdraw their money first and ask questions later. (The bankruptcy of Lehman Brothers highlighted the dangers of waiting too long to get out -- in the form of frozen hedge fund accounts.) As the stock goes down, the CDS premiums rise further, which spooks more investors and creates a vicious downward cycle for the stock -- and a short seller's paradise.

Discount retailer Dollar Tree Inc. (NASDAQ: DLTR) surprised the Street this morning with a stronger-than-expected third-quarter profit. The cut-rate retailer raked in earnings of $43.1 million, or 47 cents per share, an improvement of 23.7% over the same period last year. Analysts were expecting a more modest per-share profit of 44 cents. Revenue for the quarter rose by roughly 12% to $1.11 billion, with same-store sales increasing 6.2%.

As long as consumers maintain a death grip on their discretionary spending, Dollar Tree seems poised to benefit. Shoppers appear to be migrating away from mid-market retailers and toward discount chains, such as DLTR and Family Dollar (NYSE: FDO). President and CEO Bob Sasser stated, "We will continue to focus on the customer, and serving their needs in a very difficult economic environment."

Going forward, Dollar Tree expects that its focus on the ailing consumer will support solid earnings growth. The company once again raised its fiscal-year earnings forecast; it now expects an annual profit of $2.45 to $2.53 per share.

This week, the shareholders of Citigroup, Inc (NYSE: C) have undergone extreme trauma as the stock price plunged below $5. It's hard to believe that this company was once worth $200 billion and had a reliable dividend. Now, according to the Wall Street Journal [a paid publication], the company is having an emergency board meeting today and there is even talk of selling out to another bank.

In the meantime, Citi is trying to go on the offensive against short-sellers, who make money when share prices fall. The company is going to the folks at the Securities and Exchange Commission (SEC), who seem to be receptive. In fact, the SEC is trying to arrange a global regulatory response to short selling.

Of course, the SEC had a ban on short selling already for about a thousand financial services companies, but it has expired on October 8. No doubt, it didn't do much. If anything, the ban probably added to the overall volatility in the markets as well as reduced liquidity.

In other words, the move to ban short selling looks mostly like a cosmetic action and not something that will do anything about the deleveraging and the rampant fear on Wall Street.

As for Citi, it's just another sign of desperation. Let's face it, the company is paying the price for poor investments and risk management practices.

Tom Taulli is the author of various books, including The Complete M&A Handbook and The Streetsmart Guide to Short Selling: Techniques the Pros Use to Profit in Any Market. He is also the founder of BizEquity, a valuation website.

Have you ever noticed that the people blaming the current economic mess on short sellers tend to be either A.) loud mouths who don't know what they talking about or B.) Failed CEOs turned corporate blame shifters looking for something -- anything -- to divert attention from their own miscues: people like Patrick Byrne and Dick Fuld.

In a post on his blog, Carl Icahn came up with an argument in support of short selling that I hadn't heard before:

In simplest terms, choosing not to buy a stock because you don't like the company is like refusing to be friends with a drunk. But shorting a stock is like sending a drunk into rehab. Many of these companies, drunk with money and neglectful of risk, should have been sent to rehab a long time ago.

It's possible that aggressive short-selling accompanied by a public campaign of red flags might have pushed companies like Lehman Bros. and Bear Stearns to take a look at their risk management policies before it was too late: Certainly Lehman might have avoided its fate if it had listened to David Einhorn's warnings about leverage instead of dismissing him as irrelevant and buying back huge amounts of stock.

What an interesting time, my friends. Seriously, we're going to look back on this period and laugh about it (maybe, depends on how much you lost, I guess). Not only has the government become one huge hedge fund as the new cliche goes, but perhaps the oddest thing about this entire episode was the ban on short-sellers.

Well, they weren't totally banned. There was a list of stocks that couldn't be shorted, and they were tied to financial businesses. For instance, General Electric (NYSE: GE), a stock I own, was on the list. Why? You see, even though it makes everything from movies to healthcare equipment, a large chunk of the conglomerate deals with financial transactions. Now, the short-selling ban is gone, and financial stocks are once again subject to the whim of the trading technique.

I hated, absolutely hated, the restriction on short-sellers. It never made any sense (check out Tom Taulli's perspective on this subject).

Look, I can understand and appreciate the fact that the government had to get into the business of capitalism. At some point, there was no choice. If we all could choose, we would choose capitalism over helping a bunch of Wall Street goofballs who became intoxicated on noxious greed and who are laughing at us right now for being bleeding-heart enough to do it. We would. But, there was no choice, sad to say.

Short selling sounds un-American -- hey, it's about making money when securities fall. Yet, it has been a part of markets for centuries.

But when markets undergo periods of extreme stress, then people look for villains. Of course, short selling is an easy target.

It should not be surprising then that the Securities and Exchange Commission recently banned short selling for hundreds of financial stocks. Somehow, the hope was that it would stem the market slide.

Well, the markets have continued to crash.

Interestingly enough, one of the top investors in the world -- Pershing Square's William Ackman, speaking at Value Investing Congress in New York – thinks that the ban was one of the main factors for the loss of investor confidence.

Keep in mind that hedge funds have become a dominant player in the financial markets. They have come to rely on short selling and without the ability to make such trades, hedge funds got squeezed. As a result, there was a massive unwinding of positions.

Although, there is a silver lining. The plunge has resulted in a disconnection between fundamentals and pricing. In other words, there appear to be some compelling opportunities in the markets.

In fact, it looks like Ackman is already capitalizing on his savvy purchase of 180 million shares of Wachovia (NYSE: WB) when it got an offer from Citigroup (NYSE: C) last week. It was one of his first longs on financials in the past five years.

Tom Taulli is the author of various books, including The Complete M&A Handbook and The Edgar Online Guide to Decoding Financial Statements. He is also the founder of BizEquity, a valuation website

Earlier this week I wrote about what a bad idea the SEC's new rule requiring short selling hedge funds to disclose their positions was:

Mandatory disclosure of short positions will expose fund managers to issuer retaliation, frivolous lawsuits and harassment. What's so ridiculous about this rule is that a short position in a stock does not represent ownership of a security, and other than subjecting short sellers to harassment, there is no reason to require that the positions be publicly disclosed.

The SEC failed miserably in its responsibility to protect investors, and now it's compounding that mistake by targeting the wrong enemy.

Happily, the SEC has since seen the light. Short sellers will now be required to disclose their positions to the SEC -- which is fine -- but will not be required to make those disclosures public. If you like PDF files, you can read the announcement here.

What's so hypocritical about this is that while press releases posted prominently on the SEC website were made available for the crackdown on naked short selling and mean trash-talking hedge fund managers, you have to do a bit more digging to find the new announcement that backtracks.

It just goes to show what many of us have been saying all along: the "crackdown" on short sellers was just pathetic grandstanding by an agency that failed miserably in its duty to protect investors from misleading statements by public companies.

The Securities and Exchange Commission, or NAMBLA for short, is focusing its resources on an investigation of whether gossiping short sellers hastened the collapses of Lehman and Bear Stearns by spreading rumors.

The SEC is looking into a variety of rumors that spread in the days and months before the companies collapsed, including suggestions that some counter-parties had stopped trading with the firms.

I'll quote DealBreaker's brilliant commentary on the collapse of Bear Stearns:

Let's just say they did spread the rumors, which I don't believe they did (and, as an aside: if a company can be brought down by the corporate equivalent of 7th grade girls passing notes in class, perhaps it doesn't deserve to be in existence anyway).

It's a shame that the SEC is tossing its very limited resources into wild goose chases that serve to intimidate the people who were smart enough to predict trouble at companies like Bear and Lehman, long before either company was giving investors the full story.

In the end, the short sellers were proven right because Lehman was insolvent, and a buyer couldn't even be found at $1. You can only blame the company's management for creating that mess.

TheStreet.com's Jim Cramer says if you're short, you don't want the bill passed. Let's look at that perspective.

First, let's make an important point: Nothing from Congress is going to make this market go up. We need the market go up because it is cheap and it attracts buyers, and because there are companies out there that are worth more than they are trading at -- perhaps as private companies, perhaps as investments right now, if anyone had cash and confidence.

Right now it seems there is neither. All we have are the futures, on stocks and on oil, and they bounce around and we do what they tell us at the start. Then the hedge funds come in and start selling because of their broken models and their redemptions. Then the short-sellers come in and figure out ways to knock down things. Then the rumors start about another bank failure and then we go down.

I want to break that spiral because I own stocks. If I am short stocks, I love the spiral.

Now, the bill in Congress does not break the spiral by any means. What breaks the spiral is a sense that the system is not falling apart, which it most certainly is.

Anything that could help break that spiral is encouraging. Consider that we had the equivalent of Pearl Harbor -- the collapse of so many banks -- and now we need an effective response, which must be massive and persuasive.

Hedge funds will have to begin disclosing short positions publicly today, the first time that Main Street will get to peer into the nefarious world of people who bet against companies.

Of course, I don't think there's anything nefarious about short selling, but with some of the largest banks bleeding red ink and fading into bankruptcy or fire sales, investors smart enough to predict the current market mess have been a leading scapegoat.

So is there anything wrong with this new SEC rule? Yes, and CNBC sums it up without even meaning to: "For shareholders who have blamed short sellers for driving down company stocks, it will be a chance to see who is targeting their firm."

Mandatory disclosure of short positions will expose fund managers to issuer retaliation, frivolous lawsuits and harassment. What's so ridiculous about this rule is that a short position in a stock does not represent ownership of a security, and other than subjecting short sellers to harassment, there is no reason to require that the positions be publicly disclosed.

The SEC failed miserably in its responsibility to protect investors, and now it's compounding that mistake by targeting the wrong enemy.

It looks like SEC Chairman Chris Cox still has his job -- this despite John McCain's call to fire Cox. And what has Cox done for us lately? He's banned short selling on 799 financial stocks for the next 10 days, according to the Wall Street Journal [subscription required]. The SEC's temporary ban on short selling won't help deal with the underlying problems causing this 100 Year Crash -- but it won't make them any worse.

Short selling is one way to bet against the decline in a stock's share price. A short seller borrows shares from a broker and sells them at that market price. SEC rules give the short seller three days to obtain custody of those shares. The short seller profits by buying back the shares at a lower market price to repay that stock loan. So-called "naked shorting" -- when the short seller never obtains custody of the shares -- is considered abusive. By banning short selling, the SEC is trying to interrupt a negative feedback loop about which I posted yesterday.

This loop helped shorts profit from a decline in investment bank shares. How so? All the bad news has been driving down their shares so much that ratings agencies downgraded the investment banks' debt. Since that debt was insured through the $62 trillion Credit Default Swap (CDS) market, the downgrade threat boosted CDS premiums requiring the investment bank to post collateral in the billions. This put even more pressure on the investment bank to raise capital, driving down its shares even more.

The Wall Street Journal reports (subscription required) that the SEC will temporarily prevent investors from selling stocks short -- that is, borrowing shares and then selling them in the hopes of buying them back at a lower price later to profit from a decline in value. According to the Journal, "It's unclear whether the halt will be limited to a certain number of financial stocks or how long it would last."

The SEC had previously limited its crackdown of sorts to so-called "naked short selling", the act of selling shares short without securing a borrow. But that's a separate issue. The short selling of stocks is almost universally viewed as a valid tactic that adds to the efficiency of the market, and it's clear why the SEC is now banning it: this isn't about leveling the playing field or making the market more fair or efficient. This about the SEC using its power to manipulate the market upward.

I certainly don't think that that's a valid role for regulators to play but, if it is, why stop with a ban on short selling? Why not just implement on a ban on selling stocks? That's right: sell a stock, go to jail.

Now perceptive readers may have seen the flaw in this proposal: if no one is allowed to sell stocks, how will anyone be able to buy them? Glad you asked: let's just make it so that the only people allowed to sell stocks are insiders! That should make all the crybaby CEOs at cash-burning companies pretty happy, and apparently that's this SEC's primary objective.

UPDATE: The ban on short-selling will only effect financial stocks, per this press release from the SEC website.

TheStreet.com's Jim Cramer says this administration's hallmark is coming too late to the party.

A headline came over the wires yesterday, and it caused me to throw my hands up in shock: The SEC is debating new short-selling rules for the market.

I said to myself, "They have to be kidding."

How can they be so obtuse?

How can they not get what is going on?

When the market bottomed on July 15, three things occurred:

the Congress got religion on the housing bill, and the president went along;

gasoline and oil peaked; and

the SEC finally decided to crack down on the reckless bear raids that were making it impossible for our financials to refinance.

The financials then rallied huge, just huge, and the prudent ones, like Merrill's (NYSE: MER) (Cramer's Take) John Thain, took advantage of the short-selling crackdown and first, brilliantly, said he didn't need capital, exacerbating the plight of the shorts, and then jammed on a gigantic equity offering that will let Merrill get through this period.

Fossil, Inc. (NASDAQ: FOSL), the maker of watches and trendy apparel, surprised the Street this morning with stronger-than-expected second-quarter earnings. The retailer multiplied the positive momentum by boosting its full-year forecast. This double dose of good news has sent shares of Fossil more than 8% higher in early-morning trading.

For the recently concluded quarter, net income soared 71% to $25.1 million, or 36 cents per share, while net sales jumped 15% to $353.2 million. The results exceeded Fossil's own forecast, provided in May, for a profit of 29 cents per share on sales growth of 12% to 14%. Analysts had even more modest expectations, with the consensus calling for a profit of 25 cents per share on $346.9 million in revenue.

Digging deeper into the second-quarter figures, gross margin rose from 49.1% to 53.9%, thanks to cost-cutting initiatives and inventory management. Same-store sales climbed 5.7%, while direct-to-consumer sales surged 25%. Domestic watch sales grew by 2.3%, and international wholesale sales rose 20% (or 9.5%, excluding currency fluctuations).