By now most people recognise the death spiral we entered last month after Lehman Brothers failed. Declining asset values forced selling that has perpetuated declining asset values. The massive deleveraging in our midst is the result of real financial problems. That said, real problems should affect real asset values in real ways, as it pertained to financial companies we did expect and we saw many stock prices lose (lots of) value. And as a real recession is interpreted, we would expect further declines across relevant sectors.
However, the wild price swings in relative and absolute value of recent weeks are an extension of increased volatility in the markets since the SEC voted to repeal the uptick rule. The range and rapidity of these swings is not, as most of us can tell, a function of rapid changing earnings prospects for publicly listed companies. The market is panicked, and efficient market theorists are probably locked away playing with their iPhones and Wii’s.
From January 2005 until July 6, 2007, the highest closing value on the VIX was 18.61, and the VIX did not close once above 20. Since July 6, 2007, the VIX has hardly ever closed below the 20 mark, and it continues to set all time highs. While the credit crisis is generally still to blame for market disruption, one cannot ignore the obviousness of this point.
2008 now dominates the all-time-largest-one-day-point-gains-and-losses across indicies, including the Dow Jones Industrial Average and the S&P 500. Furthermore, ten out of twenty of the top-all-time-largest-one-day-point-losses for the DJIA have occurred since the Uptick Rule was repealed. See the charts kept by the Wall Street Journal for the data.
Investor’s Business Daily had a nice Op-Ed piece on this point today:
Investing: On July 6, 2007, the Securities and Exchange Commission voted to repeal the uptick rule for short sales. The Dow industrials then stood at 13,611, just three months away from an all-time high of 14,198. The SEC’s timing couldn’t have been worse.
About the same time, the subprime mortgage mess was surfacing and would soon escort the market on a volatile, 12-month, 40%-plus decline. Investors worldwide have suffered. Worse yet, some of our largest and (we thought) safest financial institutions have gone bankrupt.
Culprits in this yearlong financial train wreck are many. The extremes of leverage and risk taken were unthinkable. But make no mistake: Unbridled short selling also played a role.
The SEC’s fateful decision to repeal the rule has exposed us to the very same “bear raids” and “runs on the banks” that prompted the rule’s original enactment in 1934. Prudent lessons learned from the crash of 1929 and the ensuing Depression have been unlearned and, in the process, left us unprotected from predatory trading abuses and financial terrorism.
Reasons given for the repeal show a regrettably shallow understanding of the issues. Fact is, politicians have been pressured for years by influential, deep-pocketed hedge funds and financial institutions that wanted faster, cheaper trading venues and looser rules.
The SEC studied the effects of repeal by conducting its pilot program on 1,000 stocks for 12 months from May 2005 to April 2006. Unfortunately, this was a period of low volatility that saw the Dow advance from 10,404 to 11,366 in an orderly fashion. The uptick rule was not enacted for such periods of tranquility. It was enacted as a lifeboat for severe financial upheavals such as those in 1929-1933.
Another excuse for repeal was that, in the era of decimal trading, the rule is impotent. But this is not about the increments of the uptick itself; it is about the negative obligation (in specialist speak) of not being able to short a security repeatedly lower and pound it into the dirt.
Until the uptick rule is reestablished, investors must expect continued stratospheric price swings driven by all-time record volatility, perpetuated by the ability of artificial shares to be bought and sold en mass. Before that time comes, day-traders can continue to rejoice. Hedgies are on the sidelines.
If this chart below doesn’t make the point I don’t know what would. I compiled the chart from closing values on the VIX from January 2005 through today. The VIX, better known as the “fear guage” is earning its nickname. As long as artificial shares can be sold naked, without any stop-gaps, we should all be afraid.
Opposing Uptick Rule Is Truly Short-Sighted
Investor’s Business Daily, October 15, 2008
Biggest One-Day Gains, Losses
Wall Street Journal, October 16, 2008