In this morning’s Wall Street Journal, two dudes we’ve never heard of argue that the uptick rule needs to be restored to stem the “turmoil in the financial markets.” They’re probably at least half right: an uptick rule would be better than the temporary bans on short-selling and far better than any more permanent bans. But would restoring the uptick rule cut down on financial turmoil? We’re sceptical.
Ever since the Securities and Exchange Commission repealed the uptick rule last year, there has been agitation for its restoration. The rule forced short sellers to wait for a stock’s price to increase or “uptick” before they could short a stock. Even before it was repealed, when the SEC was considering a repeal and engaging in a test program, Jim Cramer was sounding the alarm. As market volatility shot up amid our broad financial crisis, the calls for the restoration of the uptick have become even lounder. But all along the case for the uptick rule has depended on mythological monsters such as “bear raids.”
Let’s pick on Cramer. Because it’s fun and he’s rich anyway, so what does he care? In March of this year he described the origins of the uptick rule on his Mad Money program. “After the short-selling bear raids that caused the crash of 1929 and the endless knockdown of stocks that followed, regulators required that there be a buyer willing to pay more for a stock than the last sale, known as an uptick, before that stock could be sold short,” he said.
Unfortunately from Cramer, there’s not a shred of evidence supporting this view of history. It’s a just-so story. Senate hearings at the time completely exonerated short-seller and debunked the “bear raid” scare stories. The hearings wound up determining that the real cause of the crash was the bubble the preceeded it. That bubble was driven, in part, by what we might call a “bull raid” on investor’s savings. Wall Street salesmen dumped toxic stocks on investors, gave the best deals away only to their friends, and encouraged speculation with bullish analysis and rumour. The crash came when the market ran out of suckers and the suckers wised up.
The uptick rule was put in place not to prevent fictional bear raids but to protect the Wall Street firms whose profits largely depended on bull markets. Like so much of financial regulation put in place to “restore investor confidence,” it was mostly a subsidy for rent-seeking special interests.
Today’s article returns to the mythology of the “bear raid.”
The SEC was warned by two commentators not to repeal the uptick rule since it limited “bear raids” — when short sellers drive down a stock’s price in the hopes of scaring other investors into dumping the stock or triggering margin calls to force liquidations. In response, the agency approvingly summarized the views of three other commentators — that bear raids “are highly unlikely to occur in today’s markets, which are characterised by much smaller spreads, higher liquidity, and greater transparency than when the rule was adopted 70 years ago.” This summary did not take into account another factor — the advent of over $1 trillion managed by hedge funds with the ability to short stocks.
But there’s little evidence of actual bear raids occuring or creating lasting damage to investors. In fact, the evidence marshalled to support the uptick rule seems to support the opposite. In the 2005 test, the SEC found that over six months stocks not subject to the uptick rule performed 2% worse than stocks subject to the rule. The SEC thought this difference was not statisically significant. But even if we agree for argument’s sake with the authors that it was significant, shouldn’t we draw the opposite conclusion that they authors of the op-ed.
“More fundamentally, return differences of 2% within six months are economically important, because annual returns in the U.S. stock market since World War II average 6% to 7%,” they write.
But why not conclude that stocks whose pricing process is muddied by regulatory interference tend to be over-priced? The only way this supports the uptick rule is if we conclude that market processes only “work” if they result in the stock market going up. But that’s just an argument for subsidized equities. Market processes should be applauded not for pushing equity prices up, but for getting them priced correctly.
We’d feel better about the uptick rule if its fans didn’t constantly resort to nonsense demonology. That said, if the uptick rule is the price we have to pay to keep the government from doing something worse, we’d support it. But we’d be a little more cautious about buying equities because we’d know that the price is floating on a bull protection bubble.
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