This is going to be a little bit confusing.
Hopefully, all of us learned about the birds and the bees. In theory, like many things, it all sounds pretty simple and straight forward.
It’s kind of like the stock market. There are the bulls and the bears. One group is optimistic and other is not. If that’s where the story ended, we’d all live happily ever after.
But like the birds and the bees, the devil is in the details.
Even though we may be soured on the market, most of us are still bulls. We buy stock with the optimistic notion that eventually it will go up. It’s all about buying low and hopefully selling when stock prices get higher.
The bears have a flip-floppy view. They sell when stocks when stocks are high with a plan to buy them back when they’re lower. This practice is known in the trades as “short selling.”
A short sale is a bet against a stock. It typically involves borrowing shares, selling them, and waiting for the stock’s price to decline before “covering” the trade and buying the shares back on the open market. The short seller keeps the difference between the higher selling price and the lower repurchase price.
In other words, short sellers profit when typical investors are losing their shirts.
Since the 1930s, regulators and policymakers have been concerned that powerful money interests can artificially depress the markets by selling short. To combat this problem, the Securities and Exchange Commission (SEC) implemented the Uptick Rule in 1938.
Then Came the Repeal
The rule required an upward move in a stock before a short sale was allowed. It made short sales more difficult by easing some of the downward pressure that builds when a market is in freefall.
In 2007, the SEC eliminated the Uptick Rule. Abolishing the rule was like cutting the bars out of the cage and letting the bears run wild.
Critics of the repeal argued that in the midst of a market that already had all the markings of a bubble, it was chumming the water for sharks.
At the time of the repeal, they argued that removing the rule would make it easier for short sellers to gang up on a stock. It would also make it cheaper for them to bet against a company, because they did not have to execute their buy-back at the higher, upticked price.
Was the Repeal at Fault?
Historically, this is how market bears get into a feeding frenzy. The first bear takes a bite and the others quickly follow. Since short sellers thrive on tips and rumors, whispered actions were much more likely to instigate an attack on a stock.
Proponents of the 2007 repeal contended that traders and market sharpies never worried much about the uptick rule, knowing that plenty of stocks that are dropping will take a momentary pause for a quick upside trade. According to the anti-uptick crowd, short-sellers and their trading partners would sometimes create those upside trades just so they could implement the short sale they really wanted to do.
Many market participants and companies blamed the repeal of the rule for the increased volatility in stocks that led to severe price declines in the fall of 2008 as the financial crisis exploded. The selling frenzy forced the SEC to implement emergency measures banning short-selling of the stocks for more than 1,000 companies during the height of the crisis. Critics claim that this emergency action by the SEC actually exacerbated the panic, and further crippled many financial firms that held short positions.
Three years after repealing this Depression Era rule, the SEC says it has seen the error of its ways. It’s bringing the Uptick Rule back.
In making their case against reinstituting the rule, uptick opponents argue that selling frenzies are more coincidental than a result of the regulatory change. They assert that even after the SEC implemented an emergency ban on short-selling in 2008, the market continued its free fall. The opponents further point out that having the uptick rule in place didn’t stop the bear market declines from 2000 to 2002 or Black Monday in1987. From their perspective, short-covering — a short-seller cashing out and taking the profits — actually helps to slow a stock’s decline.
Although the SEC has now bowed to political pressure from investors and the White House, it has incorporated some of the opponents’ concerns about the new rule.
The “improved” Uptick Rule enacted in late February triggers a circuit breaker with respect to a stock if a price declines by 10 percent or more from the prior day’s closing price. At that threshold, short selling in the security is permitted only if its price is above the current national best bid. The safety measure remains in effect for the remainder of the day and the entire following day.
Apparently, the idea is to limit the damage at 10 percent in a day. Considering that most investors would be happy making 10 percent on a stock in a year, waiting to slow a bear-driven frenzy until the stock has moved 10 percent is like inviting wolves to tea after they finished looting the hen house.
Repealing the 1938 rule was a mistake. Trying to please both sides with this alternative version of the rule is not the solution.
Instead, the SEC should say its mea culpas and reinstitute a rule that worked to protect investors for 70 years.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com
