What was the SEC thinking leading up to July 6th 2007? That is the day when the Uptick rule - a rule in place since 1934 to help keep markets orderly - was removed. The Uptick rule was introduced after the bear market of 1929 - 1932 to ensure short-sellers could not add to a stock’s downward momentum. The rule stated that short sales could only be made at a price higher than the last trade.
Famous Investor, Lazlo Birinyi has been among those calling for its reinstatement for some time and has now been joined by several members of the US Congress. It’s about time!
In a massive back-flip, after removing the Uptick rule in 2007, the SEC banned short-selling of financial stocks altogether in 2008. So a rule put in place from lessons learned in the greatest equities bear market in history was removed just before what is (currently) the second greatest equities bear market in history. What fantastic timing!
Chart 1 – SEC Actions
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A few months after the removal of the rule, the SEC claimed volatility had decreased as a result. Reading the chart below from left to right, it is hard to find support for this claim using a variety of volatility periods.
Chart 2 – S&P 500 Historical Volatility
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It could be argued the ban on short-selling financial stocks in countries like the United States and United Kingdom during the GFC - plus the total ban on short-selling of stocks in Australia - was a positive move in preventing short-sellers adding momentum to already falling prices. But it is also reasonable to suggest it added further panic – just look at chart 1! Either way, the bans simply support the idea that the Uptick rule would have been of value across the whole market during this current episode.
Not that short-selling can be made the scapegoat here. It still has its place in the market. In my experience, people who say otherwise either do not understand the markets properly or are CEOs trying to shift the blame for falls in their company’s share price. In just about every recent case of the latter, there turned out to be real fundamental issues with these stocks, rather than hedge funds simply running them down for no good reason! Consider Lehman Brothers (NYSE), ABC Learning (ASX) or Fortescue Metals (ASX). Both ABC and Fortescue continued to fall drastically even after short-selling was no longer allowed on their shares.
Equally important is the fact that short-sellers can also get it wrong! When short-sellers are wrong it creates something known as a ‘short squeeze’. This is where shorts get caught in a rising market and are forced to exit (to close their positions) by buying at a loss. This buying adds further fuel to the fire, pushing the market higher still. Short squeezes are part and parcel of the beginning of a bullish move and taking away short-selling takes away short squeezes.
I don’t think short-selling should be banned but measures like the Uptick rule would help keep markets orderly. Let’s hope that it is restored. It’s a moot point now but perhaps the GFC-inspired bear market would have been tamer if the Uptick rule had still been in place across all US stocks.