The ban on short selling some 900 financials expired last Wednesday, October 8. So what happened Thursday? Financials went into a tailspin. By the end of the day, they looked something like this:
RF, Regions Financial Corp., -22.6%
AB, AllianceBernstein Holding, -20.1%
MFC, Manulife Financial, -16.7%
WFC, Wells Fargo, -16.6%
HIG, Hartford Financial Services Group, -16.3%
TROW, T. Rowe Price, -14.4%
BAC, Bank of America, -9.9%
USB, US Bancorp, -9.6%
You get the idea. And ever since the market has been on a wild ride. On Monday the Dow soared 936 points. On Wednesday, it closed down 733 points. And while volatility can be an indicator of a top or a bottom in the market, these wide swings are unprecedented.
What's behind all the volatility? Well at least part of the cause is the elimination of the Uptick Rule. The July 6 removal of the "restrictive" Uptick Rule has made it easier for short sellers to execute trades. The Uptick Rule was implemented in the 1930's (after the crash of '29) to prevent short sellers from putting further downward pressure on a stock when the price is falling.
What, exactly, is the rule?
The Uptick Rule states that shorting is only permitted when a stock price has gone up, i.e. an uptick. This prevented shorting in a downturn and limits negative momentum on the NYSE. The Nasdaq never had this rule, so it has always been more volatile. Some analysts say the elimination of the rule may be accelerating market declines and will continue to be a factor in the market’s behavior, especially in an uncertain economy. However, the SEC believed that it compromised liquidity and was unnecessary in today’s world. And some investors believe this is a good thing in that it prevents overvalued stocks.
But shorting has become a pretty simple affair with some stocks, particularly housing and financials, almost all of which have trended down. Like everyone else now, the shorts can trade in a sell off, forcing some share prices down to the point of "worthlessness." This, ultimately, is nothing more than a transfer of wealth from one investor to another, and after a point has little to do with the value of the company. In an extreme case, it could force some firms out of business.
I believe, in the current environment, the elimination of the rule was a bad idea for the economy as a whole and for the market. Why is it necessary to re-learn stock market history? The rule served us well through bull and bear markets for some 70 years. I, for one, believe it should be reinstated.
Disclosure: The author is long MFC, TROW and BAC.
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