This article was originally published Feb. 26
Market observers are divided as to whether the elimination of the uptick rule was to blame for the stock market's sharp decline, with one side arguing that short sellers drove share prices lower while the other claims those betting on a decline are the scapegoats.
The uptick rule, instituted by the
Securities and Exchange Commission
following the Great Depression, said that the short selling of stocks could be done only after the price ticked higher above the prior sale. The rule was designed as a guardrail that slowed down the short-selling process, preventing shorts from driving the price of a stock at a faster clip.
In a short sale, an investor borrows stock from a broker, sells it to other investors, and hopes to buy it back at a lower price later before returning it to the original lender. The difference in the transactions is kept as a profit.
The SEC made the controversial decision to eliminate the uptick rule in June 2007 after its analysis showed it did little to prevent the manipulation of share prices. Of course, many market participants point to the move as the catalyst that helped short sellers thrive in 2008.
Chairman Ben Bernanke, testifying before Congress, said if the rule were still in place it "might have had some benefit" in preventing the market meltdown.
Those in favor of the uptick rule say that its removal created an environment where shorts could accelerate the failures of a number of companies, especially financial names like
and severe pressure on others, such as
"With the market that we currently have, the absence of the uptick rule leads to fairly consistent selling pressure as there's no impediment to shorting," said Thomas Sowanick, chief investment officer at Clearbrook Financial. "It's very evident in the financials."
According to a short selling study conducted for the
New York Stock Exchange
in October 2008, 85% of the 438 CEOs, CFOs and investor relations executives surveyed favor a reinstitution of the uptick rule "as soon as practical, along with other options designed to place some constraints around short selling." Eighty-two percent think bringing back the rule would help instill confidence in the market.
Sowanick said that while many other studies state that short selling may not necessarily have been the reason for the sharp decline experienced in the last few months, "everything is done at the margin. You never know where the tipping point is. Once you take away the guardrail, which is the uptick rule, you're more likely to drive off the side of the road."
Looking at Citigroup and
Bank of America
, which are both down 90% over the last 12 months, Sowanick argues that it's very clear that the shares didn't fall to current levels simply because retail investors have gotten out of their positions.
The so-called Main Street investors were made very aware of the uptick rule when they questioned why their 401(k) and mutual fund investments dwindled away over the past year, and many market observers offered up the elimination of the uptick rule as the reason. A revival of the rule is viewed as very favorable for small investors because of the residual effects.
At least some politicians are keenly aware of what a reinstitution of the uptick rule would mean for Main Street and Wall Street sentiment. Rep. Gary Ackerman (D - N.Y.) sponsored a bill in the House of Representatives that would require the SEC to restore it. The bill was referred to the House Committee on Financial Services in January.
Ackerman didn't waste much time in reaching out to Mary Schapiro, the new head of the SEC, who said she would consider reinstating the uptick rule during her confirmation hearings. On Schapiro's first day in office, Ackerman sent her a letter urging her to immediately put it back into effect.
"One of the simplest but most important and effective initiatives that the SEC could undertake immediately to combat market volatility is the reinstatement of a so-called 'uptick rule,'" Ackerman wrote in his letter to Schapiro. "While today is only your first day as Chairman of the SEC, I strongly urge you to make the reinstatement of an uptick rule your first priority; it is that important."
Former SEC Chairman Christopher Cox sent a letter to Ackerman dated Jan. 20 -- Cox's final day at the agency -- in which he offered support for returning to the rule. The note was a surprise to Ackerman considering the fact the SEC eliminated the uptick under Cox's tenure as chairman and failed to restore the regulation before the end of his term.
"I have been interested in proposing an updated uptick rule," Cox wrote in his letter to Ackerman. "However, as you know, the SEC is a commission of five members. Throughout 2008 there was not a majority interested in reconsidering the 2007 decision to repeal the uptick rule, or in proposing some modernized variant of it. I sincerely hope that the commission, in the year ahead, continues to reassess this issue in light of the extraordinary market events of the last several months, with a view to implementing a modernized version of the uptick rule."
The Argument Against the Uptick Rule
Not everyone is in agreement that the absence of the uptick rule is to blame for the market's, and particularly the financial sector's, precipitous fall. Eric Newman, co-portfolio manager with TFS Capital, says that short sellers have been unfairly blamed for the real cause of the market's decline, namely that stocks went down because they were overvalued, there was too much leverage, and too many companies didn't bother preparing for anything but the best of times.
"It's funny that when the stock market starts falling, suddenly people are blaming the short sellers, but when the market is going up the short sellers are acceptable," said Newman. "But no one has any data. When you look at the data, the opposite is true. The price improvement is there because of short sellers, and they're making the market more liquid."
Newman says that between July 15 and Nov. 14, short shares outstanding fell by more than 5 billion on the NYSE and by more than 3.5 billion on the
. But during that time, the
fell 27.5%, and volatility (as measured by the Chicago Board Options Exchange Volatility Index, or VIX) more than doubled, increasing by 132%.
"How exactly did short sellers buying back 8.5 billion shares of stock cause the market to collapse and volatility to rise?" Newman asks rhetorically. "The answer is that they didn't."
In fact, some offer the argument that short sellers should be recognized for pushing share prices lower and thereby creating new opportunities for investors to buy companies at cheaper levels. Those who don't feel the uptick rule makes a difference say that strong companies aren't defined by their stock prices, but instead by their fundamentals.
"People like blaming somebody and they don't like to admit that maybe they made a bad investment," said Newman. "It's like everyone's at a cocktail party, talking about and blaming the short sellers. The rhetoric can get pretty heated. But these stocks are falling because they're losing billions of dollars. At the end of the day, it's business and earnings that drive stock prices."
Newman says the idea the stock market was protected for 70 years by the uptick rule is laughable. "It was during the uptick rule that we had the '87 crash and we had the Internet bubble burst. Now suddenly the uptick rule is down, and it
be the shorts that are driving the prices down," he said.
Michael Pento, chief economist with Delta Global Advisors, says that in the short term, a retail investor could be hurt if a large trader is driving a stock's price down. However, "if you're a long-term investor and the company is solvent and fundamentally stable, then you have absolutely nothing to worry about when it comes to the reinstatement of the uptick rule. In the long run, fundamentals always win out."
A Better Solution?
Rather than have the SEC focus on the uptick rule, Pento argues that a much more important move would be to focus better on enforcing violations of the naked short selling ban. By definition, naked short selling occurs when a short sale occurs, but the trader does not first borrow the shares and fails to deliver on the transaction.
Naked short selling is considered extremely harmful to certain stocks because it can keep share prices artificially depressed, allowing unscrupulous traders to take advantage of the stock. While certainly illegal according to SEC regulations, many investors believe naked short selling occurs often enough to be destructive and that the SEC does little to enforce the rules against the practice.
"It's important to me that hedge funds are not able to manipulate prices down and cause XYZ Corp. to raise capital at extremely low, distressed levels," said Pento. "Having said that, if that's being looked to as the panacea to cure what ails the market, it'll be extremely disappointed."
Instead, Pento calls naked shorting the "bane of the market" and that it needs to be strictly enforced by the SEC. "No one should really be able to sell a stock without borrowing it first," Pento said. "I can't believe you can do that. You can actually short more shares than are outstanding. It's a million times more important to enforce the rules. If they enforce that rule, you don't need the uptick rule at all."
Still, others maintain their support for either the reinstitution of the original uptick rule or the introduction of a modified version of the same rule. "At a minimum," Clearbrook Financial's Sowanick said, "you would cause short sellers to think about the fundamentals of why they're shorting something as opposed to the emotion of shorting something."
But for a handful investors, even ones as well known as billionaire investor and the owner of the Dallas Mavericks basketball team Mark Cuban, the idea of the uptick rule as a viable solution isn't realistic.
"If we need an uptick rule, we also need a downtick rule," Cuban wrote in an email. "Bubbles have been far more detrimental to the health of the economy than the stock market hitting new lows."
Reiterating a post he made in December to his "Blog Maverick" Web site, Cuban suggests that "when you hear someone talk about bringing back the uptick rule as a solution, laugh. Then tell them 'Larry Bird is not waking through that door.'"