Correlation is not Causation, However the Uptick Rule Must Be Reconsidered

I know I’ve been going on about this now for over a week.  I am publishing revised studies that I put out last week below mainly because a couple of headlines  today spurred more debate over whether or not the uptick rule needs to be reinstated.  Please see my prior posts: The Uptick Rule Needs To Be Seriously Reconsidered and Follow Up To Previous Post on Reconsidering the Uptick Rule

First there was this opinion today in the Wall Street Journal by Charles E. Schwab, the founder and chairman of the financial services firm that bears his name. Restore the Uptick Rule, Restore Confidence

Then there was this Bloomberg headline in part defending the removal of the 74 year old rule.  Uptick Rule May Fail to Lift Stocks, Curb Volatility

Then the story got picked up by Cramer, who I hate to side with. Cramer’s ‘Stop Trading!’: Uptick Talk

At the end of the day it is easy to look at some facts, including the ones in my studies below and conclude that our current volatility was caused by the repeal of the uptick rule.  As I have said before and will repeat, I do not think correlation is causation, but I do believe that markets need to become more efficient before people can settle on the right prices for risky assets.  Until the markets calm down, I don’t think that can happen.  Subsequently with the frequency and magnitude of the swings we have seen recently, I don’t think the markets can normalize without stricter regulation.

The argument in today’s Bloomberg article defends the SEC’s decision on July 6, 2007 to repeal the then 73 year old rule which was put in place to stabilize uniquely volatile markets during the great depression:

When Citigroup plunged 26 percent on Nov. 20, the steepest drop on record for the New York-based bank, downticks represented 7.1 percent of trades, according to exchange data compiled by Bloomberg. On Oct. 9, as both Morgan Stanley and Merrill Lynch & Co. shares had record declines, trades on a downtick represented 16 percent and 11 percent of transactions, respectively.

“That suggests that the price is collapsing not so much because sellers are hitting progressively lower bids, but because there are effectively no bids,” said Frank Hathaway, chief economist at New York-based Nasdaq.

I agree that these names plummeted because the bid has walked away, however, I do believe that one of the largest reasons the bids are walking away is because there is no reprieve for buyers when a stock can drop precipitously in a world without the uptick rule and with the added pressure of ultra high volatility and hefty dose of pessimism.

The other factoid missing from the argument above is that in the absence of the uptick rule, the speed with which the prices can fall is alarming.  So while sales on downticks may only represent a small percentage of the actual trades, this statement says nothing for the magnitude of the fall during those downtick trades.

It is well known that a large portion of the daily volume is traded not by people but by computers running fancy trading algorithms.  It is also well known that this type of trading has been adding to the recent volatility, causing great swings in the last couple of hours and sometime the last few minutes of the trading day.  Arguments defending the SEC’s decision cite the idea that because technology is so advanced and because stocks trade in pennies as opposed to sixteenths that the uptick rule is antiquated.  This argument supposes that the uptick rule was instituted in an era of severe inefficiency, and that having it in place helped make markets more efficient.  However the flip side of that argument is that with lightning fast speed, markets have been created to exert hyper-efficiency.  As a result unmanned computers now have the ability to ride downward momentum in prices in the blink of an eye.

Here are my revised studies, all together, through close of business December 9th, 2008.

Occurrences of Larger Than One Percent Swings (Absolute Value) in the S&P 500 Since the Repeal of the Uptick Rule on July 6, 2007

Occurrences of Larger Than One Percent Swings (Absolute Value) in the S&P 500 Since the Repeal of the Uptick Rule on July 6, 2007

Occurrences of Larger Than One Percent Swings (Negative Only) in the S&P 500 Since the Repeal of the Uptick Rule on July 6, 2007

Occurrences of Larger Than One Percent Swings (Negative Only) in the S&P 500 Since the Repeal of the Uptick Rule on July 6, 2007

Occurrences of Larger Than One Percent Intra-Day Swings (Absolute Value) in the S&P 500 Since the Repeal of the Uptick Rule on July 6, 2007

Occurrences of Larger Than One Percent Intra-Day Swings (Absolute Value) in the S&P 500 Since the Repeal of the Uptick Rule on July 6, 2007

And don’t forget that securities lending is a very lucrative business, particularly at a time where securities firms are facing insurmountable pressure on other revenue streams.  Securities lending is the business in which brokers lend shares of a stock to clients in order to sell them short.  In the transaction, the broker is paid a handsome interest rate for each day the shares are borrowed based in part on how hard the shares are to locate/acquire (how liquid the stock is).  As Michael Moore recapped what I think was originally Marx: “One of the most ironic things about capitalism is that the capitalist will sell you the rope to hang himself with.”

While I understand that correlation is not causation, I am fully convinced that equity markets will not return to “normal” until the uptick rule is reinstated.

Sources:
Restore the Uptick Rule, Restore Confidence
Charles R. Schwab, Wall Street Journal, December 9, 2008
http://online.wsj.com/article/SB122878208553589809.html?mod=googlenews_wsj

Uptick Rule May Fail to Lift Stocks, Curb Volatility (Update1)
Edgar Ortega and Jesse Westbrook, Bloomberg, December 9, 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=ag2QOVwVr_dU&refer=home

Cramer’s ‘Stop Trading!’: Uptick Talk
TheStreet.com, December 9, 2008
http://www.thestreet.com/story/10452256/1/cramers-stop-trading-uptick-talk.html?puc=googlefi&cm_ven=GOOGLEFI&cm_cat=FREE&cm_ite=NA

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2 Responses to Correlation is not Causation, However the Uptick Rule Must Be Reconsidered

  1. […] bookmarks tagged lucrative Correlation is not Causation, However the Uptick R… saved by 4 others     SakuraBoriqua bookmarked on 12/10/08 | […]

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