How Much Can We Blame the Uptick Rule?

by: Bespoke Investment Group

There have been a number of headlines in recent weeks on whether or not the elimination of the uptick rule (a stock no longer has be shorted on an uptick) in July of last year has contributed to the market's declines or at least the pickup in volatility. While it is hard to argue with the fact that volatility has picked up since July, it's important to remember that the no-uptick rule was in place for a large number of stocks as the market charged higher from the middle of 2005 to 2007.

Way back in 2004, the SEC announced that it would suspend the uptick rule on designated securities in the Russell 3,000 as a pilot to see how the stocks and the market would react. The pilot ended up consisting of about 1,000 stocks and didn't go into place until May 2nd, 2005, with an expiration in April 2006.

While the pilot didn't get much coverage when it was announced or finally put in place, here is an article from The Wall Street Journal back in 2004.

If the no-uptick rule was really the root cause of the market's declines and increased volatility, shouldn't the market have struggled much more than it did from mid-2005 to mid-2007 when the pilot was in place? The pilot consisted of 1,000 highly-liquid stocks that all had associated options. Below we highlight a chart of the Russell 3,000 from 2004 to present. Had you looked at the chart in July 2007 right before the uptick rule was officially eliminated, one could make the argument that no-upticks across the board could make the market go higher!

Jim Cramer has been all over this issue in recent weeks as an opponent to the no-uptick rule. While some may think he's irrationally blaming the market's declines on the no-uptick rule, he has in fact been criticizing it for some time now, and his commentary definitely suggests that other issues are contributing to the fall. But after a Google search, we did find an ironic article that he wrote just prior to the pilot period. Below are some excerpts from the article that he wrote on April 29, 2005:

"Just when you thought it couldn't get nastier for the "longs" out there, the people who just play from the long side, the SEC passes the Hedge Fund Relief Act, and it goes into effect Monday. Oh, it's not called that. It is just the suspension of the "uptick rule." But it certainly will have that impact, for both the hedge funds and the market.

This rule change, of course, couldn't come at a worse time. The market's terrible. Longs are beleaguered, shorts are emboldened. I think it is fair to say that things are about to get a lot worse, a lot faster for the stocks of bad companies without the slowdown circuit breaker of the uptick rule. But the SEC, in its non-infinite wisdom, dreamed this little doozy up and all I can tell you is that you ain't seen nothing yet."

As shown in the chart below, his "couldn't come at a worse time" comment actually came at a great time to buy stocks, all but disproving his argument for the next few years.

While the no-uptick rule might be contributing to some increased volatility, it's hard to blame it (and not the other glaring issues) for the downward pressure on the market.

We're in the process of analyzing the performance of all the stocks included in the pilot program to see how they traded versus stocks that weren't included during the effective period.  And by the way, BSC was included in the pilot.