The Uptick Toward Disaster

The Uptick Toward Disaster
August 5, 2007
Question911.com

There has been a major change in the rules for the stock market and I have been able to find no major newspaper that has covered it. Yesterday I was going through my mail and reading a financial advice newsletter I have subscribed to for 20 years. The man who writes it has a method for investing in commodities and is not known for hyperbole, but this headline shocked me: THE STOCK MARKET COULD BE HEADING FOR DISASTER

Well, that got my attention, so what's the deal? Well it turns out that to understand this news you need a little history. In the 1920's the stock market had no restrictions on short selling stocks.

For those of you who do not understand short selling, it is a bet placed that a stock will go down in value. To make this bet with a broker, the broker "borrows" stock from his vault (physical or electronic) of other people who hold the stock and sells it on the open market. This is not illegal for him to do because presumably he can always purchase more from the market if necessary. The short seller, having sold the stock, hopes to repurchase the stock at a later date at a lower price, thus making a profit from the decline.

So when the stock market crashed in 1929, the biggest traders shorted by the boatload, hoping to buy back everything at low prices when the crash was at bottom, and the Dow Jones Industrial Average dropped 90%. When the Securities and Exchange Commission was formed in 1932, one of their first tasks was to write a rule about short selling to protect the small investor so that such a crash would never occur again.

They wrote the "uptick rule" or Rule 10a-1, under the Securities Exchange Act of 1934, which states that short selling is only permitted following a trade where the traded price was higher than the previously traded price (uptick). This basically means that unless a stock has just traded for a higher price, you cannot short sell it, preventing a constant slide in the price.

So what changed? The so-called "Uptick rule" was removed on July 7, 2007 (7/7/7) after 73 years of protecting the investing public, the SEC has removed this rule, allowing for unlimited and unrestricted short selling of any stock.

Some say this is just a technical correction, but the world we live in is quite different than the world of 1929. In today's world we have more mutual funds than we have stocks to invest in, we have trend following computers whose only job is to watch every tick of the market and jump on any trend they see and try and profit from it, and we have day traders and millions of casual investors who can trade at the speed of a mouse click.

We also have hedge funds, which have been in the news of late, and they have collective assets of 3.8 TRILLION dollars plus 5 times that much in borrowed funds, and if they hit the market during a downward trend, they now have the ability to leverage billions of shares to amplify the downward trend.

These enormous hedge funds could even act together to hammer individual stocks, taking a $50 stock to $40 in one day, $30 the next day, and just as Joe Public gets scared and sells his stock, the hedge funds buy them back and reap their profits from the honest American investor.

So who does the majority of stock short selling? The individuals or the institutions (the smart money)? In the SEC study institutions were found to account for a whopping 75% of short activity.

This is could mean that the owners of this country - the richest people in the world - are ready to cash out their holdings. This rule allows them to immediately withdraw all of the value in the stock market.

Now, is this news or not? There IS an article in Forbes magazine where they discusses the uptick rule. The article comes up at the top of the list when you Google the term. But the article is from 2001 and includes an SEC denial that the rule is to be changed. For some reason "no change" is news but changing the rule gets no coverage in Forbes at all?