All Hail the Uptick Rule!

By David Gaffen
An already exuberant move in the equity market was bolstered by none other than Barney Frank (D-Mass.), who said he expects the “uptick rule” – a requirement done away with in July 2007, which required investors to wait until a company’s stock rose before it could be sold short – to be restored in about a month.That the removal of the uptick rule has damaged markets has been an article of faith for investors for months. The rule was removed in July 2007, and markets have tanked, ipso facto, the uptick rule is responsible. (The second pillar of evidence comes from the past- it was first put in place in 1938, at the tail end of the worst period for stocks in history. Once again, quod erat demonstratum.) Never mind, of course, the overleveraged financial industry sinking as if trapped in a tar pit under the weight of bad loans and the high cost of servicing their debt.

Since the rule was officially suspended on July 6, 2007, the markets have gotten hammered. Volatility has certainly picked up, with the Chicago Board Option Exchange’s volatility index rising from levels in the low 20s to the 40-to-50 range it finds itself in currently. Traders were indeed glad to hear that discussions were taking place. Gordon Charlop, managing director at Rosenblatt Securities, said that “the fact that they’re looking at it and discussing market structure is positive.” He tempered his enthusiasm, saying that “as far as the short-sale rule specifically, it still remains to be seen.”

That may be because the evidence to support reinstating or forgetting about the rule is thin. A non-profit research institute called the New England Complex Systems Institute conducted a study released in November 2008 argued that the number of stocks with big percentage declines increased after the uptick rule was done away with (authors of the study wrote an editorial in the Wall Street Journal in November). They found that there were 32 instances in which an individual issue saw a 40% drop in one day or more in the 12-month period beginning Sept. 30, 2007, compared with just 14 names in the 12-month period beginning March 31, 2000.

The problem, however, lies in the issue of correlation vs. causation. Markets have also been roiled by the banking crisis – one that has been compared unfavorably to the Great Depression – and economic growth contracted in the fourth quarter at its greatest rate in 25 years. It’s going to repeat that trick in the first quarter. In the meantime, short interest has declined rapidly in the last several months. As of July 15, 2008, just after the rule was rescinded, New York Stock Exchange short interest totaled 18.608 billion shares; on Feb. 13, 2009, it had declined to 13.802 billion shares.

“I think it’s a feel-good thing so Congress and everybody involved can act like they’re doing something concrete,” says Eric Newman, a portfolio manager at TFS Capital. “I don’t think the short-sellers have made it any worse.”

Still, the rule may end up fading into the sunset before long. And if it does – after major averages have declined by more than 50% in one of the worst bear markets in memory – some will invariably point to the rule’s restoration. Quod erat demonstratum.

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