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NEW YORK (Reuters) - Short selling of financial and automaker stocks has fallen sharply since July, as traders balk at the dimming prospects to profit from these battered shares and the U.S. government increases control over the economy.
Traders and experts expect the trend to continue, and caution that it could exacerbate volatility and weaken a key safeguard against stocks becoming overvalued.
Short selling, the practice of selling borrowed stock in hopes of buying it back at a lower price and pocketing the difference, was a popular trade in the past year, a period of extreme stress in the financial and auto industries.
But since July 10, short interest on financial companies has fallen nearly 40 percent to an average of 3.68 percent on November 14, according to Short Alert Research data released this week.
Among brokerages, the decline in short interest - the ratio of stocks sold short to overall shares - was an even greater 43.5 percent.
Short interest in automakers has declined 32 percent in the past five months to roughly 11.5 percent, with short calls on General Motors Corp (GM.N) halving since August.
"It's a greater liquidation than anything I've ever seen," said Mike Long, partner at Short Alert, who has tracked short interest for 15 years.
The decline comes as shares of these companies hit historical lows on investor concern for their financial health. Shares of Citigroup Inc (C.N) hit a 16-year low last week, while GM stock fell to its worst levels in 70 years.
Short sellers expect fewer gains are possible with share prices scraping these lows, said traders and analysts.
"It goes against conventional wisdom that short sellers pile on as stocks go to the ground," said Richard Gates, co-portfolio manager at TFS Capital.
But as stocks drop, "shorts run for the hills and take their bets off," Gates said. "I expect it to continue."
Some corporate executives have blamed short selling for driving down their companies' stock prices, as Citigroup alleged last week.
On November 20, Citigroup asked the U.S. Securities and Exchange Commission to bring back a ban on short-selling financial stocks. The request came during a week when Citigroup's stock tumbled 60 percent to $3.77, the lowest level since December 1992.
Lehman Brothers executives also blamed short sellers for their bank's demise. A few days after Lehman filed for bankruptcy, the SEC responded by imposing an emergency ban on short selling of 800 financial services sector stocks.
The effectiveness of the ban is in question - financial stocks underperformed the market for the entire duration of the ban until October 8, when it was lifted.
The recent decline in short calls, also reflected in numbers from Data Explorers Limited, suggests short sellers were not the cause of Citigroup's share slide.
Earlier this month, short calls on Citigroup were just 2.3 percent, Short Alert data shows. Data Explorers' figures indicate the number of stocks on loan - considered a proxy for short selling - was 1.8 percent last week.
Experts say traders have pared their short covers on fears that U.S. bailouts could trigger a rally in stocks that could wipe out their profits.
Further, the SEC has implemented emergency rules to crack down on so-called "naked" short selling, when traders sell short without borrowing the underlying stock, scaring off some short sellers.
"How greedy do you want to be?" said Bill Rhodes, chief investment strategist of Rhodes Analytics. "Do you want those last two to three points or do you want that thing to pop back in your face?"
Still, some investors welcome the addition of further layers of protection, saying short sellers would "get used to it," said Frederick Lipman, a securities lawyer with Philadelphia-based law firm, Blank Rome LLC.
But others lament the declining trend, arguing that if the SEC makes it harder to short stocks, the market was in danger of becoming overvalued.
"If you drive short selling out... recovery periods are much longer and more difficult, and the volume on the market is much thinner," Rhodes said. "It doesn't help stop selling."
Editing by Kenneth Barry