Major imbalances in the global economy, dangerous misconceptions and pricing of risk, inadequate capital requirements, lax oversight, poor corporate governance, greed and a host of other fundamental problems were the root causes of the stock market crash we are living through. But repealing the “uptick” rule in July 2007 was akin to taking off the snow chains before entering the highest mountain pass in the dead of winter, with a perfect storm on the horizon.
Our stock markets have never fallen so far, so fast. Psychologically damaged investors are fleeing, afraid to take any degree of prudent risk in what appears to be the complete absence of market stabilizing forces. Despite countless attempts and unimaginable sums of taxpayer money aimed at programs that were hoped would indirectly help calm the markets, why is it that one simple measure that would have direct impact--- costing nothing more than the stroke of a pen --- has yet to be implemented? As the chorus grows louder from market professionals, main street investors, corporate executives, members of congress, and other knowledgeable players --- for crying out loud, bring back the “uptick” rule.
In response to destabilizing “bear raids” on stocks that contributed to the 1929 crash and its volatile aftermath, the “uptick” rule was instituted in 1938 by the SEC as an important step to boost investor confidence. The rule stipulates the “short sale” of a stock (a bearish bet from someone who doesn’t actually own the stock) can only be executed at or above the last price paid if that was higher than the one before---hence on an “uptick”. This was designed to prevent short sellers from piling on a target company’s stock, panicking investors to abandon their positions or sometimes have them liquidated, involuntarily and inopportunely, to meet margin calls. Clearly, short selling provides a valuable role in a free market, aiding price discovery, helping contain unrealistic euphoria in individual stocks and to punish company managements and their investors for making financially unsound decisions. A patient, long-term investor ---say, investing for retirement --- can withstand short sellers’ impact on a financially sound company whose stock price has levitated beyond economic reason. But, no investor should have to suffer a bear raid that severely injures, or dooms, a financially viable company that has temporarily been caught in the crosshairs. It can have devastating effect, when this happens to important institutions that provide credit and liquidity, as the fear creates funding problems potentially leading to collapse, triggering defaults and a negative contagion of write downs and ever-weakening balance sheets, sucking liquidity out of the system just when it’s needed most. This is the nightmare many Americans experienced in their portfolios in 2008 and, if still invested, continue to fear today.
Critics of the rule argued that it impeded proper price discovery and was becoming obsolete in the era of electronic exchanges. The SEC conducted a short trial in 2005 --- a relatively hospitable period for stock market investors --- analyzed by its economic staff. Based on findings from the study of that trial, SEC commissioners concluded that the rule was no longer necessary and eliminated it in July 2007. But the findings could arguably have been misinterpreted. Reaching a very different set of conclusions, a more recent analysis by the New England Complex Systems Institute argues that the elimination of the rule had negatively effected the stocks in question---in a potentially meaningful enough way to alter investor behavior. Compounding the error, the repeal couldn’t have come at a worse moment, just as the subprime crises erupted, leading the credit and stock markets into a tailspin. Indeed, analyzing market performance during similarly terrible twelve month periods this past decade, these same researchers found a statistically significant increase in the number of jaw dropping one day individual stock price declines (>40%) in the period absent the “uptick” rule compared to while it was still in effect. A little known term outside the professional investor community for decades, retail investors are ever more frequently hearing about the absence of the “uptick” rule as one of the reasons why their once thought to be “sleep at night” stocks are suddenly down 50% or more from one brokerage statement to the next.
There have been many calls over the past year to reinstate or at least re-evaluate the rule. Respected leaders of investment services firms (that may sound oxymoronic but the ones I refer to had nothing to do with creating the witch’s brew of toxic mortgages) have argued for reinstatement. House representatives sponsored a bill to order newly appointed SEC Chair Mary Schapiro to reinstate the rule as a first priority. Fed Chairman Ben Bernanke recently said the rule “might have had some benefit” in the midst of the crash. And echoing a study done by the NY Stock Exchange, where 80% of senior corporate executives said reinstating the “uptick” rule would help instill market confidence, NYSE CEO Duncan Niederauer stated bluntly last week “when markets are psychologically damaged like they are right now I actually think it will go a long way to adding confidence.” Even former SEC Chair Chris Cox now claims to have been interested in reinstating the rule towards the end of his tenure but was apparently unable to convince fellow commissioners.
At her confirmation hearings in January, Mary Shapiro testified that re-examining the rule is “one of the things that I would be committed to doing very quickly”. But in the meantime, US equity markets have dropped another 20% or so, while a spokesperson for the SEC recently stated there was no specific proposal under consideration. Undoubtedly, there are a number of difficult and complex issues for the SEC to address with urgency, but this is one that should be moved to the front of the queue --- what’s taking so long?
To borrow an often-used phrase from President Obama --- this is not a silver bullet. But it may be a psychologically important one. And the markets are in need of anything that can have a potentially soothing effect. Its time to press the reset button on a poorly informed and ill-timed decision and President Obama, I have a suggestion for you. Fire up the chopper and head to the NYSE to announce that you have ordered the SEC commissioners to work quickly to implement a new version of the “uptick” rule---to be followed shortly by other measures to ensure enhanced oversight and regulation of all securities markets. And while you’re at it, don’t forget to ring the opening bell on what will hopefully mark the beginning of the new road to restoring investor confidence.