Opposing Uptick Rule Is Short Sighted
On July 6, 2007, the Securities and Exchange Commission voted to repeal the uptick rule for short sales. The Dow industrials then stood at 13,611, just three months away from an all-time high of 14,198. The SEC's timing couldn't have been worse.
About the same time, the subprime mortgage mess was surfacing and would soon escort the market on a volatile, 12-month, 40%-plus decline. Investors worldwide have suffered. Worse yet, some of our largest and (we thought) safest financial institutions have gone bankrupt.
Culprits in this yearlong financial train wreck are many. The extremes of leverage and risk taken were unthinkable. But make no mistake: Unbridled short selling also played a role.
The SEC's fateful decision to repeal the rule has exposed us to the very same "bear raids" and "runs on the banks" that prompted the rule's original enactment in 1934. Prudent lessons learned from the crash of 1929 and the ensuing Depression have been unlearned and, in the process, left us unprotected from predatory trading abuses and financial terrorism.
Reasons given for the repeal show a regrettably shallow understanding of the issues. Fact is, politicians have been pressured for years by influential, deep-pocketed hedge funds and financial institutions that wanted faster, cheaper trading venues and looser rules.
The SEC studied the effects of repeal by conducting its pilot program on 1,000 stocks for 12 months from May 2005 to April 2006. Unfortunately, this was a period of low volatility that saw the Dow advance from 10,404 to 11,366 in an orderly fashion. The uptick rule was not enacted for such periods of tranquility. It was enacted as a lifeboat for severe financial upheavals such as those in 1929-1933.
Another excuse for repeal was that, in the era of decimal trading, the rule is impotent. But this is not about the increments of the uptick itself; it is about the negative obligation (in specialist speak) of not being able to short a security repeatedly lower and pound it into the dirt.
Besides, the rule does not have to apply to an uptick of a few cents. It can just as easily require, say, a 10-cent uptick for stocks priced below $20, and 25 cents on those above.
The evidence that volatility has increased after the rule change is powerful. A study by Birinyi Associates in April 2008 shows that after the rule change the VIX (Volatility Index) increased immediately from 13.25 to 23.55. In addition Birinyi showed that during the same period, the absolute dollar value of the daily change in each stock in the S&P 500 increased to $1.77 from $1.02.
Even more compelling is a chart showing the volume of stocks purchased on plus ticks (higher prices than prior sale) and those purchased on minus ticks (lower prices).
The real date — July 6, 2007 — shows an immediate and dramatic shift in volume from plus ticks to minus ticks, suggesting unbridled shorting pushing prices lower. Proponents of the repeal say these data are just coincidence. We think not.
Finally, much has been written and reported about the role of predatory shorting in the demise of Bear Stearns and Lehman Bros. Clearly, both of these venerable investment bankers were in serious trouble. Yet, if one carefully analyzes the price and volume action in the final five days of their dramatic declines (when most of the damage was done), the evidence is compelling.
Bear, with a float of 159,098,000 shares, traded down from $61.58 to $2.84 in just five trading days (March 14 to March 20) on stunning volume of 669,737,000 shares, or 4.2 times its total float.
Lehman had similar footprints, diving from $16.20 to 15 cents in five days on almost three times its floating supply. In the process of these startling declines, these firms' ability to fund their businesses disappeared, and both failed.
All this, according to many crusty old traders, smells like a replay of the 1929-33 bear raids that the uptick rule was designed to prevent from ever happening again. Proponents of repeal think not. The difference is that the traders can shake their heads and move on to the next trade.
Those who stand by the repeal must bear the burden of knowing that their poorly researched decision and reluctance to admit their mistake has put our very nation, our markets, our economy, and indeed our national security at risk. The uptick rule needs to be reinstated now.