Thursday, August 09, 2007

Where the Hell Are the Upticks?

In a blog primarily concerned with the manipulation of language and tradition to suit America's suicidal left, an entry on our current financial situation might seem a little out of place. But then again, maybe not. This entry is meant to voice our serious concern over a little noticed "manipulation" of a longstanding securities regulation meant to insulate small investors from wealthy thugs who want to kill off small investors and pocket the profits. The term and regulation we're talking about is Wall Street's seemingly arcane "uptick rule."

This is a little tough to discuss in a short entry, but we'll give it a shot. Most people, when they think of investing in the stock market, think that the way you make money is to buy a stock for, say, $10 and sell it for $15. That way, you make $5. (Less commish, of course.) In trading jargon, this is described as a "long" position. I.e., if you buy 100 shares of company X, you're long 100 shares of company X.

Well, that's one way of investing in stocks. For the professionals, or for more daring individuals, there's a second way, a trickier way. It's called "shorting a stock," or establishing a "short position."

In another life, Wonker actually spent several years as a stockbroker/investment advisor, and actually taught investments at a local community college. Wonk conducted investment class, in many ways, like Jim Cramer does now on "Mad Money," trying to simplify the complex and add a little entertainment to help make this crazy business understandable and even a little fun. Ironically, this was back in the late 1970s-early 1980s, just when Cramer was starting to run OPM (other people's money). Who knew that this kind of approach would one day prove highly lucrative on TV? Certainly not yours truly. But, as they say, we digress.

My point is, describing short sales to newbies was always one of the more challenging items in Wonker's course since, to the average little-guy investor, nothing seems more perverse, more at odds with natural law and the Word of God than the short sale.

When you sell short you borrow, say, 100 shares of company X that you don't own. The cash flows into your account. The game here is that you want the stock to go DOWN, not up. Is that nuts, or not? No, it isn't. If you shorted 100 shares of company X at, say, $10, you take $1000 into your account. If the stock sinks to $5, which is what you want, you scoop up $500 dollars of that cash and BUY THE BORROWED STOCK BACK. Your profit is the money you have left: $500.

Now shorting is inherently riskier than the "conventional" way of investing in the market. But it's one way that you can make money even when the Dow is waterfalling to oblivion, like it is doing at this very moment.

For you old timers, clever shorting is how Joe Kennedy Sr. made a lot of his fortune. And it was even more fun in his day. Why? Because you could team up with some of your buddies. You could start by shorting company X at 10, then let your pal short it again at 8, then let pal #3 short it at 6, all with big trades, and you and your friends could completely trash the stock, wiping out all the suckers who held onto it before closing your position. This is part of the reason, at least, why Wall Street had such a tough time gaining equilibrium in late 1929, and even thereafter when things actually got worse.

So enter the Roosevelt administration which really did try to level the playing field for the little guy, closet socialists that they all were. In the mammoth and landmark Securities Exchange Act of 1934, one of the things they did was institute what's known as the "uptick rule." Wickipedia has as good a definition for this rule as anyone:

'Uptick' is the name generally given to Rule 10a-1, under the Securities Exchange Act of 1934, which states that short selling is only permitted following a trade where the traded price was higher than the previously traded price (uptick).

On the New York Stock Exchange a short sale may only be done on an uptick or a zero plus tick (which occurs when the price is the same price as the last trade, but higher than the previous different trade).

On the NASDAQ, shorting is only allowed on the bid side when the current inside bid is not lower than the previous inside bid (i.e. a downtick).

Okay. If you don't totally grasp this, that's fine. To oversimplify (which is mostly what I'm doing in this entry anyway), the uptick rule forbids the next guy after you from shorting more shares of the same stock unless at least one other guy buys it and moves it up a notch first. This still doesn't necessarily prevent a stock from tanking. What it does accomplish, however, is a slowing down of the process which, oftentimes, allows enthusiasts of the stock to jump in and buy, blunting the downward force of what could have been an orchestrated short by professionals. It also means that if the shorting continues, the little guy will get ample opportunities to get out before he's crushed.

Although Wonker is an unabashed capitalist, he's seen too much to want the financial bigwigs to have the stockmarket sandbox all to themselves. Every time you do this, everyone gets hosed. The bankers, the utility monopolies (they used to have them), and the Joe Kennedys of the world whipped up the speculative froth in the late 1920s that resulted in the Crash of 1929. In later eras, when financial institutions were deregulated, starting in (believe it or not) the Carter Administration, the result was the severe Crash of 1987 and the following Savings and Loan debacle which required a massive government (i.e., taxpayer funded) bailout. Still looser regulations didn't help with the Dot Bomb of 2000-2001. And an inability to reign in today's notorious hedge funds or limit the use of exotic mortgage instruments has brought us to today's liquidity mess.

Basically, you can only trust rich investors so far. The genius of the American system so far is that it allows for almost unrestrained capitalism. But it's careful to do mid-course corrections to hem in the excesses of the professional thieves who do business on Wall Street.

Well, lately, that American genius has been going awry, as per the above examples. And now, the latest, which leads to our opening point. Last month, the 1934 securities act was again amended to ELIMINATE the uptick rule. Read the document here. In so doing, you'll read some mumbo-jumbo about how this is going to provide a more "consistent regulatory environment" for short selling. What a bunch of nonsense. What eliminating the uptick rule HAS accomplished is an almost immediate and dramatic increase in the volatility of the stock market.

As a result of this elimination of the uptick rule, which once again commenced barely a month ago, we are witnessing a breathtaking increase in market volatility, and it's scaring the bejeebers out of the small investor. And probably wiping out a lot of them, just as the easing of mortgage rules has led to a lot of little guys losing their houses.

Eliminating the uptick rule, particularly in the middle of massive failures within the financial system due to the massive repricing of real estate loans that should never have been made, is like throwing gasoline on a fire.

Wonk is going to look into just how this happened and see if there's anything he can do to put the genie back in the bottle. Eliminating the uptick rule has just subjected the small investor to the same kind of ruinous volatility that signaled the end of the 1920s bull market and threw millions of people out of work.

We love competition in the markets. But not when it lacks the kind of circuit breakers, like the uptick rule, that can prevent financial panics from morphing into a complete fiscal Armageddon seemingly overnight.

Oddly, in this case, we here at HazZzMat regard the uptick rule as yet another in a series of American traditions that have been thrown overboard. The destruction or subversion of cultural traditions ruins the heart and mind. The destruction, subversion, or in this case elimination of a perfectly serviceable fiscal tradition is going to ruin a lot of wallets and bank accounts.


Trevor Stasik said...

I hadn't heard that the rule was eliminated. I don't think all of our volatility would be created by this, however I agree that it could be a factor. Your reasoning makes some sense.

Wonker said...


Thanks for posting your comment. The rule was indeed eliminated the first week of July. The Wikipedia entry I ctied begins with the specifics, which I did not cite. Namely:

"The Uptick rule is a former financial regulations rule, relating to the trading of securities in the United States. The rule was eliminated by the SEC, effective July 6, 2007."

Obviously, the background and description provided in my blog entry are a little simplistic, but I figured if I dwelt too long on the arcane details of this mechanism, I'd lose any readers I'd hoped to gain. And I find to this day that when I try to explain shorting to the average guy, 9 out of 10 refuse to believe that this kind of transaction is even legal!

Obviously, ALL the volatility we're experiencing is not due to the elimination of the rule. I agree. In fact, the rule's elimination in and of itself was probably unlikely to cause anything major. Except at the wrong time. Which is what seems to have happened.

The rule was dropped precisely at the worst possible inflection point in the financial markets, when the real magnitude and depth of the debt crisis was finally becoming obvious after many months of speculation. The SEC seemed clueless here, dropping this little fiscal IED into fray at almost exactly the worst time possible.

What's going on here is that the missing uptick rule is now dramatically magnifying or exaggerating the moves of even low beta stocks in this market, making for some treacherous whipsawing, the worst I've seen since the Dot Bomb. Such wild gyrations are frightening even to some seasoned professionals. This kind of activity is likely to panic out all but the most savvy investors, or perhaps the ones who have nerves of steel.

Bottom line: we're in a bad patch here, and the lack of an uptick rule is making the pain far, far worse and far more dangerous than it would have been otherwise. Ben Bernanke has his work cut out for him here. It may be very difficult to keep rates steady at this point while still trying to contain what is clearly a growing liquidity panic.

On the other hand, from a purely moral point of view, it would be good if a few of these high-flying hedge fund managers got completely wiped out. It would be a good way of teaching this crowd that the taxpayer isn't going to bail out every clown who tries to play fast and loose with other people's money.

Tough call for the Fed and Dept. of Treasury. Next couple of weeks will show us if they're worth their salaries.

Anonymous said...

It is interesting. I heard the "Uptick" law being talked about by Larry Kudlow on WABC yesterday morning.

Wonker said...


Yeah, I am hearing the missing uptick rule mentioned here or there, but no one seems to be focusing on the obvious. Namely, that the lack of the uptick rule after, what, over 70 years in place more or less, is definitely a factor in accelerating the downdrafts in this market. I'm not really sure why the missing uptick rule is not attracting the attention it deserves. This is slightly arcane, sure, but it's not exactly rocket science either.

It's probably time to bring the rule back and say, oops, I'm sorry. Never mind.

But, since such an admission of error would shorten the careers of a few bureaucrats, I'm not expecting them to do the right thing.

That's why bureaucrats and/or politicians always use passive phraseology in public pronouncements. Not "I goofed." Or, "Gosh, we made a mistake." But, rather, "Mistakes were made." Possibly by gremlins or poltergeists. Maybe by pod people. But certainly not by me. Or any of my friends. The "mistakes" just seem to have materialized. Who knew?

Wonker said...

UPDATE: Finally, our friends at the Wall Street Journal have noticed what's going on, although their article tilts in favor of academic types who feel the missing uptick rule only minimally distorts things.

Sorry. The lack of an uptick rule is considerably distorting things at precisely the wrong time. The missing uptick rule is allowing an unprecedented amount of stock to be dumped STRAIGHT DOWN by liquidating hedge funds.

This is why there is no escape from this downdraft. The hedgies are/were into everything, highly leveraged, massive positions. Evidence for this? Precious metals, oil, large cap stocks, small cap stocks, you name it: on a bad day lately they all waterfall down. In the history of the modern market, such activities are an anomaly.

Gold, perhaps, provides the best example. The Iranians are forging ahead to manufacture nukes. The Pakistanis are in danger of imploding. Terroristas continue to hatch plots. Democrats are totally in favor of energy independence just as long as it doesn't involve drilling in Alaska, burning coal, building new nukes, or putting windmills off Hyannisport. Oh, yeah, and Rove isn't leaving DC until the end of the month.

So gold goes way up, right? Wrong. It's being dumped in the futures markets, and, more important to our argument, it's being dumped via mining companies. Precisely when it should be going up. The hedgies are dumping positions straight down to the bottom, and the usual defenses are no longer holding due to the missing uptick rule. (Which the Journal reporters for some reason call the "downtick" rule.)

The current mess will not be worked out until the hedgies have completed their massive dumping operation. Given their holdings, this could go on for quite awhile.

In the meantime, smaller investors are clinging to a boulder right down to the bottom of the trading sea. With this kind of dumping, plus no uptick rule, there's very little chance to get out.