The Uptick Rule |
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The current situation with the uptick rule is an excellent example of how
ignorance of nonlinear dynamics can cause tremendous problems. I will
argue that a simple rule change made by the SEC in 2007 is the reason for the
large magnitude of the decline in stock value over the past year. Despite
the fact that this rule change has caused trillions of dollars in loss to stock
holders (1), the SEC steadfastly refuses to reinstate
it.
For those unfamiliar with this discussion, in 2007 the SEC repealed rule 10a-1, otherwise known as the uptick rule. The uptick rule was implemented in 1938 to prevent unrestricted short sales of stocks. Despite almost unanimous calls for its reinstatement, the government refuses to reinstate the rule . The lack of press in this issue is disconcerting, and is no doubt due to a lack of understanding about the nature of the problem. This article will try to address this issue by showing how ignorance of nonlinear dynamics and basic science lead to the problems we face today. I will begin by a review of the history behind the uptick rule. I will show how the government's own study predicted a stock market crash and how they ignored their own results that predicted a crash if the rule was repealed. I will then discuss how the removal of the rule has opened the door for criminal activity by unscrupulous stock brokers. I will finish by suggesting that we need to scream at president Obama and the SEC until they hear the voices calling for reinstatement of this rule. While this may seem to be extreme advice, it is based upon the SEC's own discussions, in which they suggest that a rule needs to scream for attention before they will adopt it. |
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History of the Uptick Rule The uptick rule was laid out in the Securities Exchange Act of 1934 by Joseph P. Kennedy, Sr. The uptick rule was intended to prevent "Bear Raids" on the stock market through unrestricted short selling. Joe Kennedy had been hired by Franklin Roosevelt to insure that the problems that caused the crash of 1929 were fixed so that a repeat crash would not occur. Joe Kennedy was a "robber baron" that got rich by using predatory practices and market manipulation. When it was pointed out that Joe Kennedy was a crook, Franklin Roosevelt said, "It takes one to catch one". When Mr. Kennedy was charged with protecting the stock market, one of the first things he did was to install the uptick rule to protect investors. |
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How the SEC ignored the results predicting a stock market crash if the
uptick rule was repealed One of the more amazing aspects of this story is how the SEC ignored the results that predicted a stock market crash if they repealed the uptick rule. The SEC did a study before removing the uptick rule to see if any harm would come from taking it away (2). They took 1000 stocks selected at random from the Russell 3000 and removed the uptick rule on the 1000 stocks for 6 months and compared their performance with the other 2000 stocks in the Russell 3000. They noted that, for the stocks on the NYSE, the 6-month return of was 2.38% less where the rule was temporarily lifted vs. leaving the rule in place. The 6-month return was 2.09% less for test stocks on the NASDAQ exchange. Because these reductions were not statistically significant, they decided to ignore them. Lets examine their logic a little more. What is statistical significance? Basically, it means that, based upon the sample used, we can conclude that the results are different from zero in 19 out of 20 cases. If a result isn't statistically significant, it doesn't mean the results aren't accurate, it just means that there is a more than 5% (1/20) chance that they aren't different from zero, so we ignore them. Even though the results were not statistically significant, there is a difference between statistical significance and economic significance, and this was pointed out by Harmon and Bar-Yam (3). Let's assume for the moment that the 1000 stocks where the uptick rule was removed actually did have a 2.38% (2.09% for the NASDAQ) lower return in a 6-month period. That means that the predicted reduction in annual return would be twice that, or 4.76% less than normal. What is the significance of this reduction? Well, the historically adjusted annual return for stocks is about 7.0%. If the annual return is 4.76% less than the 7.0%, that leaves an annual return of 2.24% on NYSE stocks when the uptick rule is not in place. We have to ask ourselves what would happen if the NYSE only produces a 2.24% annual return, or 66% less annual profit that it did before the rule was repealed. The 7% return that stocks normally produce is what brings money into the stock market, since it is higher than a bank normally pays in interest. What do you think will happen if the stock market starts producing a net 2.24% annual return? A fifth grader could predict that everyone will pull money out of the stock market and put it in banks, and this is exactly what happened. |
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The significance of statistical insignificance The story doesn't end there however. The fact that the mean loss in return was statistically insignificant indicates that the distribution of possible values, given many repeat tests, included zero. The distribution of possible values that the significance level is based upon is two tailed. That means that the mean loss in return, given many repeat tests, could have also been about twice the 4.76% measured mean loss in return, or 9.52%. This is greater than the 7% average return of stocks, and indicates that removing the uptick rule might have guaranteed a loss in value from stock investments. This may seem like a somewhat absurd argument, but it follows directly from the math involved in statistical significance. People need to understand what statistical significance is before they ignore results. If you read the Wikipedia article on statistical significance, it is clear that the confidence intervals should be used, which in this case would have resulted in a 95% confidence that the results were most likely between a number slightly higher than zero and a number slightly less than a -9.52% annual change in return, with the most likely value being a -4.76% change in annual return. |
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How the repeal of the uptick rule leads to increased market volatility The SEC pilot study (2 - p. 71) showed that there was an approximately 20% increase in extreme price reversals for stocks with no uptick rule compared with stocks that still had the uptick rule. The difference in price reversals was significant at a p<.01 level, but the investigators explained the differences away because there was an approximately 20% increase in price reversals in both directions. There are several problems with their logic. First, the study was done in a period of relatively low overall market volatility. Since the uptick rule has been repealed, the number of extreme down swings in stocks has increased dramatically. In the study by Harmon and Bar-Yam (3), a comparison was done on the number of high volume stock price drops after the Internet bubble burst in 2000, causing large drops in stock prices, and in September 2007 after the repeal of the uptick rule in July of 2007. The differences vary from +129% for 40% drops, +325% for 50% drops, +450% for 60% drops, and several price drops in the 70% and 80% range in 2007 where there were none in 2000. The problem with not having an uptick rule in a down market is that there is very little pressure to reverse a short sale attack. Stock prices can be thought of as being similar to a weight on a spring as shown in Figure A. A price change can cause oscillation in the price over time. If there is sufficient liquidity on the market, the oscillations will damp out over time, returning to a fair value as shown in Figure B. If there is no upward pressure to compensate for the price drop, the stock simply loses value and drops to the bottom as shown in Figure C. The collapse of several large banks and brokerage house stocks such as Bear Stearns and the Lehman Brothers have followed this pattern. |
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How removing the uptick rule leads to criminal activity by stock brokers There is several side effects of removing the uptick rule, but one is particularly egregious, and that is the practice of naked short selling (4). In legal short selling, the seller is required to either own or borrow stock to list in the short sale. In naked short selling, the broker doesn't bother with that step and simply offers stock for sale at a short sale price, and then buys the stock later at a reduced price once they cause the stock price to go down. Naked short selling is not illegal (10), and enforcement of rules that shorts must be covered is extremely difficult and time consuming. We never had this problem before, since short selling was not as lucrative when the uptick rule was in place. Without the uptick rule, we are inviting more criminal activity by stock brokers. The actual level of naked short selling is not known, but one indication is the failure to deliver stock to cover short sales (9). In the fourth quarter of 2006, failures to deliver averaged 53,325 trades per month. In the fourth quarter of 2007, after the repeal of the uptick rule, the failures to deliver averaged 62,312 per month, a 16.9% increase. Failures to deliver are down in the fourth quarter of 2008, due to an SEC crackdown on the practice of naked short selling, but still averaged 30,088 trades per month. This reduction in uncovered trades indicates a greater care to cover short sales, but does not mean that naked short selling is down. |
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What to do about this problem This issue is really a no-brainer when you look at it. The solution is to simply reinstate the uptick rule. According to a survey done in October of 2008 (6), 85% of stockbrokers surveyed favored reinstatement of the uptick rule to bolster investor confidence. Christopher Cox, former chairman of the SEC, suggested in a letter to Gary Ackerman (7) that he favored a more stringent uptick rule that the one that had previously been in place. Federal reserve chairman Ben S. Bernake told the House Financial Services Committee that “In the kind of environment we have seen more recently” the so-called uptick rule “might have had some benefit” (8). It is hard to understand why the SEC is dragging their feet. Their initial decision was based on a flawed interpretation of the results of their pilot study. If you read the initial discussions by the SEC, there really was no urgent reason to repeal the uptick rule in the first place (5). The uptick rule was seen as a minor inconvenience. The discussions by the SEC indicate that the need for a rule must scream and not whisper. I think it is time for us to scream at the SEC, the president, and our elected officials to get off their rear ends and put this rule back in place. We went for 70 years with an uptick rule in place and had no market crashes like the current one. The Dow Jones Industrials have already lost 50% of their value. Do we wait until the percentage drops to 89% like the 1929-1932 crash before taking action to protect ourselves from predatory trading? You can send an email to the following people by clicking on the links. Simply tell them to Reinstate the Uptick Rule. The link for this web page is http://www.nonlineardynamics.org/Default.ASP?Page=UptickRule |
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References
(1) I claim that the current crisis is no worse that other crises in the past, and that the magnitude of the loss approaches the 1929 crash simply because the uptick rule is missing. I did not find data indicating the total loss in this crash, but a 778 point drop in the Dow caused a $1.2 trillion dollar loss (Stocks crushed: Approximately $1.2 trillion in market value is gone after the House rejects the $700 billion bank bailout plan.), which suggests that the 6500 point drop in the Dow Jones average from near 13,000 to 6,500 indicates many trillions of dollars in lost value. (2) The government study can be found here. U.S. Securities and Exchange Commission (2007). Economic Analysis of the Short Sale Price Restrictions Under the Regulation SHO Pilot The page where the results are shown is on page 69. (3) The problems with the SEC pilot study are numerous and I have been focusing on a small subset. The rest of the issues are discussed in Harmon, Dion, & Bar-Yam, Yaneer (2008). Technical Report on SEC Uptick Repeal Pilot (5) If you check out the conversation on page 114 of the discussions about the repeal of the uptick rule (Securities and Exchange Commission Roundtable on the SHO pilot) by Mr. George Sofianos. He states "Substantial benefits are needed to justify a regulation, and here is my sound byte. I want the need to scream, not to whisper." (6) New York Stock Exchange Survey (7) Letter from Christopher Cox to Gary Ackerman (8) Bernanke Says There May Be Benefit to Uptick Rule (9) Failures to deliver stock to cover a short sale (10) The Truth About Naked Shorts Other Links
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