In a post I wrote a month and a half ago I offered some evidence that the repeal of the uptick rule on July 6, 2007 may have been a large mistake. While it would clearly be wrong to say that the repeal of the uptick rule has caused our current crisis, it may not be far from the truth to now say that our current crisis will likely continue until the uptick rule is put back in place.
The research study undertaken by the SEC that led to the decision to repeal the 73 year old rule on July 6, 2007 was conducted during a period when volatility was as historical lows. Volatility has remained at historical highs almost ever since the rule was repealed, see my old post here.
The work I have done here, while admittedly anecdotal, is incredibly supportive of this statement from Investor’s Business Daily on October 15, 2008.
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.
In considering how else to explore this concept I thought to look at the number of trading days in which markets have moved widely in percentage terms from the close on one trading day to the close on the next trading day.
For the purpose of this study I selected the S&P 500, and looked at all of the trading days since the rule was repealed (357 trading days between 7/6/07 and 12/2/08), and then looked at the equal number of trading days before the rule was repealed. I looked at the sum of occurrences in which the S&P 500 moved widely and studied moves larger than 1%, 2%, 3%, 4%, 5%, 6%, and 7% in absolute value (up or down). Then for further effect, and insight, I looked at all trading days since the last trading day in 1949 (effectively January 1, 1950). The results of that effort are below, click to enlarge.
The few people who got a sneak peak at this were stunned. If there is any bit of anecdotal evidence that we need to re-investigate the SEC’s decision, this is it.
As an example of how to read this, consider the number of occurrences of a 3% or greater swing. Since 7/6/07 (through yesterday) there have been 39 occurrences of a 3% or greater move, positive or negative. Before 7/6/07, in as many trading days, there was only one. Another way to read this is that 10.92% of all trading days since 7/6/07 have seen larger than a 3% swing. Vice-versa, in the same time period prior to 7/6/07 only 0.28% of the trading days closed with such a wide swing from the prior day’s close. The “Multiple of Occurrences” line is simply the multiple (in percentage terms) of the recent period to the prior periods. Thus in this example of 3% swings, 10.92%/0.28%=39.
And of course this does nothing to speak to the number of trading days that have seen intraday swings in excess of many of these studies. I know that would be far greater… maybe another project!
After showing this to a colleague, he said that he’d be more convinced it was the uptick rule if he could see a similar study outlining only the down days. So to oblige I have pasted that study below. This is similar to the one above, however instead of using absolute values (up and down), it is only focused on occurrences of down days.
In any event, we all know how volatile the markets have been, at the very least we can feel it in the pits of our stomach each day. However, one takeaway from this study is that for market mechanisms to function, they need to be rational. The frequency and magnitudes of the recent market swings throws efficient market theory out the window, but it also perpetuates fear and risk aversion that keeps investors away from risk-assets. Our system cannot regain any balance until the market mechanism (never mind the actual economy) regains proper footing. It is one thing for the economic reality to be bleak, but orderly markets allow investors to price risk appropriately, and buy assets with fair assumptions whether right or wrong. It is hard to argue that the size of the swings we are seeing in equity values are justified, but it is easier to argue that such swings will continue to keep investors on the sidelines, feeding the current liquidity trap, and forcing more deleveraging.
While I do not think the uptick rule removal has caused our current woes, I think it was incredibly poorly timed, and I do believe that until we see it reinstated, no matter what the size the bailout package grows to, and no matter how many industries get a shoulder to lean on from the Fed, that we will continue to see disorder prevail in the equity markets. Furthermore, since equity markets are a leading indicator for the real economic picture (historically) I think we will continue to be in for a wild ride moving forward.
We cannot underestimate the importance of rational markets. While publicly traded equities are only a portion of financial assets, as the most public assets they rightfully or wrongfully set the tone for investor confidence. I don’t think reinstating the uptick rule will make the real economy better, but I do, now, sincerely believe that stabilizing markets will lead investors back into risky assets, creating a virtuous cycle that can calm and if only mildly lift markets (or deflate markets) to a reasonable equilibrium. Until then, keep your seat-belt tight.
Credit Crisis Aside: It’s the Uptick Rule, Dummy!
Greenewable, Greenewable’s Weblog, October 16, 2008
Opposing Uptick Rule Is Truly Short-Sighted
Investor’s Business Daily, October 15, 2008