Short Sales, and the Uptick Rule Revisited
While the recent rebound in share prices has perhaps reduced some of the more strident calls for its reinstatement, the abolishment of the uptick rule in 2007 is to many, part of the reason that stocks have struggled so much over the past year. Supposedly the alleged piling on among short sellers in down markets turned orderly share declines into routs.
That being the case, had the uptick rule been in place whereby bears could only have sold short shares whose price on the last printed trade had ticked upward, we could have supposedly avoided the sick-inducing market declines of the Fall. Notably, similar thinking carried the day during the Great Depression, and the uptick rule was created. The problem then was that it did not produce the desired effect when it came to improving the direction of markets.
Back in the early ‘30s, much like last fall, federal curbs on short sales were put in place. But as is well known now, they didn’t arrest stock-market declines. This was unsurprising given the basic truth that today’s short seller in falling markets is tomorrow’s buyer as short sales are covered.
It was assumed back then that short sellers were driving down stock prices, but to suggest this was to ignore the many legislative mistakes that made shares unattractive. Those included, but were not limited to, the imposition of the Smoot-Hawley tariff in 1930 that retarded trade and the efficiency wrought by an expanding worldwide division of labor, FDR’s increase of the top tax rate from 62 to 79 percent, and our departure from the gold standard. In short, the blame placed on short sellers in the ‘30s ignored the true causes of ill health within the stock market.
And with stocks not having recovered in the way investors liked by 1935, another rule with regard to short sales was added to the previous ones. On May 27, 1935, the SEC ruled that no member of the stock exchange could “use any facility of the exchange to effect on the exchange a short sale in the unit of trading below the last regular sale price.” This was the “uptick rule” that so many want restored today.
It should be said that the Dow Jones Industrial Average rallied from 109 on June 1, 1935 to 190 by August of 1937 while this rule was in place. But were the two related? It has to be remembered that on the same day of the imposition of the uptick rule, the Supreme Court unanimously voted down the economy sapping National Industrial Recovery Act (NRA). As Hillsdale professor Burton Fulsom recently wrote, under the NRA, the federal government was enabled in its desire to oversee “how much a factory could expand, what wages had to be paid, the number of hours to be worked, and the prices of products.” The NRA turned entrepreneurs into lackeys of the state, with predictably bad results.
Further along, from August of 1937 to March 31, 1938, the Dow dropped from its aforementioned high of 190 all the way to 97; all this with the uptick rule in place. The imposition of the Wagner Act and the resulting rise in unionism no doubt played a role here, but this merely speaks to the importance of short sellers. Had they not been hamstrung by the uptick rule, they doubtless would have profited from the market’s aforementioned decline, but they also would have arguably arrested it above 97 given their desire to take profits on their short sales.
Shares ultimately recovered a lot of their gains by October of 1939 with the Dow at 155, but far from an effect of the uptick rule, this was merely due to the fact that the last significant piece of New Deal legislation was passed in 1938. By 1939, the makeup of Congress had changed for the better, FDR’s “court packing” scheme had failed, the Undistributed Profits Tax had been repealed, and with war possibly in the future, FDR knew well that he could no longer impose economy-enervating rules on business.
The uptick rule on short sales was softened somewhat in 1944, and it remained in place as was previously noted until 2007. Still, despite this allegedly bullish banning of bad news and trading from the markets, investors weren’t spared major declines in the ‘70s, in October of 1987, or during the Internet bust of 2000-2002. Bear markets don’t spring out of nowhere, or thanks to eased rules on short sales, but are the natural result of government error. In the ‘70s it was dollar debasement combined with high rates of taxation, in 1987 it was the threat of further dollar weakening in concert with looming protectionism and curbs on leveraged buyouts, and in 2000 markets reversed due to a deflationary dollar followed by the 2002 passage of Sarbanes-Oxley, a bill meant to turn entrepreneurial CEOs into accountants.
Looking at markets today, Benjamin Anderson once observed about inflation that it “may seem harmless for a long time and then suddenly break forth into great violence.” Anderson’s words describe this past decade well. For a time the falling dollar brought cheer to the housing sector, and banks prospered. But the money illusion can only last so long, and eventually the inflation which revealed itself in the gold price broke forth with great violence. Stocks hate inflation, and then the federal government piled on with economy-retarding stimulus plans and corporate bailouts that turned what should have been a relatively benign decline into something much worse. The uptick rule is being partially blamed for stock declines that history tells us we should have expected.
Peeking into the future, it should be hoped that the uptick rule isn’t reinstated. Unfettered markets when it comes to the trading of shares don’t so much cause market declines as they allow for markets to reach their natural level as quickly as possible. This alone is a positive, not to mention that the bearish short sellers who perhaps bug us when stocks are falling will, if left alone, give us cheer when they cushion the seemingly endless declines that bother us even more. Let’s ban the efforts to banish the uptick rule, a measure that would only serve to reduce the number of stock buyers when we need them the most.