This article was originally published Feb. 26Market 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. Even Federal Reserve 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 Bear Stearns and Lehman Brothers and severe pressure on others, such as Citigroup ( C), Goldman Sachs ( GS) and Morgan Stanley ( MS). "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.
The Argument Against the Uptick RuleNot 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 Nasdaq. But during that time, the S&P 500 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 must 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."