Uptick Rule: Correlation Does Not Imply Causation

According to a recent Wall Street Journal article, the SEC is being deluged with letters supporting the return of the uptick rule. Pressure for the rule has been building since the market melt-down last fall, generating additional interest this spring (see previous post). Let me state upfront that I believe when regulators interfere with the natural flow of the market, as they did when banning the short selling of financial stocks last fall, it does more harm than good - primarily by reducing market efficiency and increasing volatility when temporary restrictions are lifted. Besides the irony of helping to reduce risk management opportunities, adding an uptick rule seems ineffective for liquid markets, for which it is not all that hard to find a plus tick.

Nonetheless, I understand and appreciate the arguments on both sides - primarily that we did fine with it for near 70 years. I am also not sure it will make much difference one way or another. Yet the current debate seems to expand the argument, and fall into the trap of assuming correlation implies causation. This is apparent in the following quote:

Isn't it coincidental that right at the time the uptick rule was abolished, the sharp spiral downturn started.

While we can debate whether the market began falling July 6, 2007, or later that year, does it really matter? Could it also be argued that the rule was artificially propping up a market that should have long since fallen under the weight of a housing bubble? Is it the rule change that caused the market to crash, or did it simply get out of the way of the inevitable pent-up selling? Is there any difference? Was something else at play?

One current argument goes on to say that not only should the uptick rule come back, but that naked short selling should be banned, capital ratios should be increased, the CDS market should be regulated, and leveraged ETFs should be examined. All worth examining. But if the CDS market becomes more regulated (a near given), current naked short selling rules are enforced (not such a given), and leveraged ETFs are restricted, is the uptick rule even necessary? Should we require a little more evidence?

As an additional reason for changing the rule, another advisor mentions that the repeal of the rule "drastically changed the outcome of many stocks this past year." Last I saw, so did greedy banks and home owners, yet we seem to be forgiving many of their problems, and even making it easier for them to become whole, but I digress. Yes, when bad companies are sold, they tend to go down. Maybe the market needed to drastically change. Was there overshooting, sure, but markets have a tendency to overshoot, in both directions.

Maybe the real point of contention is given by another advisor quoted in the article, stressing that reinstating the rule will help "investor psychology." Possibly, but is this a reason for bringing the rule back? And which investors are they talking about? Will the psychology of short-sellers or hedge funds be better off? Probably not, and maybe that is the point. Many blame the hedge funds and short sellers specifically for destroying their nest eggs. It only seems natural to want to punish them, but does it solve the problem? Once again, I don't think it does.

We have to be careful when assuming that one thing causes (or doesn't cause) something else. In fact, I know that some will argue that I am falling into the same trap. I agree. In fact, that is the point. When we interfere with and observe one outcome or property, and try to describe what we are seeing, the less we know about the other paired property, not unlike what Hiesenberg observed over 80 years ago. Controlled studies are needed, but as with quantum physics, this is difficult for dynamic markets.

Maybe the next time the markets begin to fall we should spend less time assuming it is only caused by a structural flaw in the system, and more time understanding if something fundamental to the market started the selling. The market may be telling us something early on. If we had listened a little earlier, maybe we would be months and years into the next recovery and figuring out when and how to short the next bubble (which, if the uptick rule is reinstated, may be more inevitable).

Comments

[robert.b.fe...:]

There was never a good reason to repeal the uptick rule or Glass/Steagal. Naked shorting should be illeagal and so should derivitives call those toxic bets what they are. While short selling is a good and nescesarry method naked shorting amounts to theft.

Jun 11 09:18 AM

[frosty:]

If the uptick rule did no harm for 70 years, then what is the harm of reinstating it? As you say, " . . . an uptick rule seems ineffective for liquid markets, for which it is not all that hard to find a plus tick." But then again, perhaps it might be effective in limiting abusive shorting practices. Who knows? I side with do "no harm for 70 years."

As to naked short selling, this should be a crime. In essence, it allows anyone in the world to create shares for the purpose of selling them. Only boards of directors should be allowed to create shares in their own companies. I would love to sell my neighbor's house, but I don't own it and he won't lend it to me. If I sell it anyway (and get caught), I will go to jail.

Shorting rules and laws need to be tightened because so much trading is dominated and controlled through program trading by hedge funds and other less public mega-investment groups. It's not the normal individual independent investor like you and me who abuses shorting practices, rather it is the outfits with the sophiticated computer models. They shouldn't be allowed to create stock for sale just so they can make a short term profit which naked shorting seems to be mostly about.

Jun 11 09:21 AM

[john redmond:]

The uptick rule is much ado about nothing. In fact what should be done is the elimination of short selling all together. Short selling is like whole life insurance, nothing but another form of stealing that has been honed and polished for decades to the point that it almost tastes good going down..

Jun 11 09:57 AM

[dddd:]

The part this author misses (knowingly) as well as others who are being paid by the short establishment to bash the UPTICK rule and/or shorting regulations, is:

There will always be a seller. Human psychology is designed to panic on the down side, but be fearless on the upside.

So in other words the whole shorting establishment is designed to prey on this psychology. The only thing protecting the individual investors are rules that make shorting more difficult than buying.

Jun 11 10:31 AM

[KirbyJF1:]

David

People with your thinking have propelled investing in stocks to be the same as a roulette wheel in a casino. The Uptick rule provides time to allow individual,Institutions, Funds & Institutions the opportunety to determine if there is actually a problem with a company , who's stock is declining & not some Hedge fund Or market maker trying to manipulate the stock down to cover a position or to lower the price to enable them to accumalate the security on the cheap. I for one wanted to be an investor, not a Casino player. All the Wall Street Banksters & their Hedge fund minions play the same game as the Trusts in 1929. ((Bear Raids to take the money from the Great Unwashed)) Individuals such as your self are doing a great disservice to capitilism & investing by trying to take safegaurds from the market. As far as the SEC goes , they only handle disputes between the Wall Street Titans & the hedge funds. I for one & a number of my freinds are seriously considering pulling out of investing in the Great Casino, you short term players want us to invest our hard earned money. That includes mutual funds who take our money & loan the shares out to Hedge funds, so the mutual fund managers can get their vigerish. IMHO

Kirby

Jun 11 12:55 PM

[grinninbrit:]

Kirby,

You want to be an "investor" and not a "casino player." Sounds admirable but I hope you realize that it would take more years than any of us have left to make the US Stock market "pure investment". You don't start with some silly short regulations. You simply start and/or scale in removal of all margin (for purposes of short and long), outlaw hedge funds (that play games with "investor" greed on the upside just as much as "investor" fear on the downside.), outlaw any FDIC insured bank from in any way being tied to a business that buys/sells/owns securities. Brokers still exist but they can't loan out for shorting shares bought on margin to other players that want to long stocks on margin. Again, stocks bought long on margin have created the casino in as great a way also. Guess what the market for the "investor" would look like if we start unwinding all margin, either in one fell swoop or over 10 long painful years ? Your dreaming if you think you have ever been or ever will be an "investor" and not a "casino player"

Jun 11 04:54 PM