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. Famous Investor Lazlo Birinyi has been among those calling for its reinstatement for some time and has been joined by several members of US congress.
The uptick rule was introduced after the bear market of 1929 to 1932 as a measure 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. In what can only be described as a massive back flip, after removing the rule in 2007, the SEC banned short selling of financial stocks completely in 2008. So a rule put in place from lessons learned in ‘The Great Depression’ was removed not long before what has been dubbed ‘The Great Recession’. What fantastic timing!
Chart 1 – SEC Actions
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A few months after the rule’s removal the SEC claimed that 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
click to enlarge
The ban on short selling financial stocks in countries like the United States and United Kingdom during the GFC, plus the a total ban on all short selling of stocks in Australia, can be argued as a positive move in preventing short sellers adding momentum to already falling prices. However it is also reasonable to suggest it added further panic as well – just look at chart 1. Either way the ban simply supports the idea that the uptick rule would have been of value across the whole market.
Not that short selling can be made the scapegoat here. It still has its part in the market. In my experience people who say otherwise either a). do not understand the markets properly or b). are CEOs trying to shift the blame for falls in their company’s share price. In just about every case of the latter point, there turned out to be real fundamental issues with these stocks rather than hedge funds simply running the stock down for no good reason. Look at Lehman Brothers (NYSE), ABC Learning (ASX) or Fortescue Metals (ASX). Both ABC and FMG continued to fall drastically after short selling was no longer allowed on their shares.
Just as important is the fact that short sellers get it wrong too. 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 by buying to close their positions – normally 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. Taking away short selling takes away short squeezes.
With that in mind, while I don’t believe short selling should be banned, it is important to have measures like the uptick rule in place to keep markets orderly. Let’s hope that it is restored. It’s really academic at this point, but who knows? Maybe the bear market as a result of the GFC would have been (somewhat) tamer if the uptick rule had still been in place across all US stocks.