Yesterday, Charles Schwab, the founder and CEO of financial services firm and broker/dealer Charles Schwab & Company*, published an opinion in the Wall Street Journal entitled "Restore the uptick rule, restore confidence."
In it, he argues that it is time to restore the uptick rule, which prevents selling stock short until after the price of a trade moved up relative to the previous trade (called an "uptick").
Mr. Schwab notes that the SEC removed the uptick rule, which had been in place since 1938, after a brief study in July of 2007, a study which only examined stock market movements between 2005 and the first part of 2007, a period of exceptionally low volatility. He argues convincingly that the removal of the uptick rule removed an obstacle to bear raids and market manipulation characterized by short-sellers "betting heavily on lower prices and triggering panicked investors to sell even more."
We have long argued that the SEC could have prevented the disastrous chain reaction on Wall Street , which led to a credit panic and which has now impacted the entire economy, by the simple regulatory steps of removing the mark-to-market rule and restoring the uptick rule. In fact, the day before Mr. Schwab's article was published, we said it again in this post (see here).
Like Mr. Schwab stressed in his article, we do not have any problem with the institution of short selling in general. Taking a bearish position on stocks is an important check on stock prices and a self-correcting force within the markets, and helps the markets perform their function as one of the world's most efficient processors of information (economics texts often call them a giant "price discovery mechanism"). Even though at Taylor Frigon Capital Management we discourage short-term speculation and encourage investment in businesses with a long view of their business prospects, we published a post back in August entitled "Give the traders a break" in which we made that very point.
The larger point in the context of the continuing financial unrest is that we believe there is ample evidence that the great panic of 2008 was a self-inflicted wound, rather than a collapse of capitalism caused by a system-wide failure by Americans to save enough, or their desire to just spend money they didn't have and never do anything virtuous or productive.
Certainly there were imprudent decisions made in some sectors of the economy, but the inexplicable failure of regulatory bodies to remove or suspend the disastrous effects of mark-to-market accounting and to reinstate the time-tested uptick rule has allowed a problem in one small subsection of the overall mortgage market to metastasize into a world-wide problem.
With the proper perspective on the cause of the current economic difficulty, however, investors are better able to make decisions for the future and to better assess the exaggerated predictions of those who believe we are witnessing the end of our economic system as we know it.
* The principals of Taylor Frigon Capital Management do not own securities issued by Charles Schwab and Co. (SCHW) .
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For later posts dealing with this same topic, see also:
- "Big news on mark-to-market accounting" 03/13/2009.
- "Four-letter government words" 04/15/2009.
- "The end of 2009" 12/30/2009.
- "Being short is not automatically evil" 04/27/2010.
I read with great interest your posting, specifically "but the inexplicable failure of regulatory bodies to remove or suspend the disastrous effects of mark-to-market accounting and to reinstate the time-tested uptick rule has allowed a problem in one small subsection of the overall mortgage market to metastasize into a world-wide problem."
ReplyDeleteThe uptick rule is "time-tested" ostensibly because the market has generally gone up over time. But that is an odd statement. Did the uptick rule fail us in October of 1987? What about when the S&P fell by more than 40% between 2000 and 2002?
Proponents of reinstating the uptick rule essentially claim, "Because stocks go down, short sellers are to blame." Between 9/19 & 9/26, WAMU fell by 96%. Is it those manipulative short sellers again? Well, no--short selling was banned in hundreds of financial companies during this time, including WAMU.
Let's be clear: Short sellers are not In fact, the data shows that short sellers serve to regulate
price-- they are part of the few who are buying when stocks go down, and selling when stocks are going up. Stocks go down because they are overvalued. There was too much leverage, and too many companies didn’t bother preparing for anything besides the best of times. Let's stop blaming the short sellers already.
Hi Eric,
ReplyDeleteThank you for your comments. If you notice our earlier post from August called "Give the Traders a Break" (http://taylorfrigon.blogspot.com/2008/08/give-traders-break.html), you will see that we defend short-selling as serving to regulate prices, just as you assert in your comments. So perhaps you misunderstand us if you think we believe that short sellers are to blame, as your comment seems to indicate.
However, in our opinion, the removal of the uptick rule was a factor among other factors including new mark-to-market accounting regulations that contributed to conditions that did not exist in previous decades.
The academic study upon which the removal of the uptick rule was based ran from May 2, 2005 for one year (later, the terminal date was extended until August 6, 2007). That study is available on the internet at http://404.gov/news/studies/2007/regshopilot020607.pdf. It is our opinion that an examination of such a brief period of time, covering a period of below-average volatility, was probably not the best justification for the removal of the uptick rule. Furthermore, the narrow scope of the study also left out the psychological effect which is a factor during a market panic, which is what took place in fall 2008.
Perhaps the adjective "time tested" was not the best descriptor for the uptick rule, but in our opinion the rule did not cause inordinate problems for the seventy-five years it was in effect. On the other hand, its removal only helps those who profit from increased volume, and makes driving down a stock much easier.
Again, we have no problem with short selling as an institution. However, we believe that if the study that forms the academic basis for the removal of the uptick rule were expanded (if it had covered the period of fall 2008, for example) it would probably show very different results -- results which would support the continuation of the uptick rule.