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Up Tick Rule and the Stock Market Short Avalanche

2008-10-21 17:19:00

Up Tick Rule and the Stock Market Short Avalanche
I have a good friend from University by the name of Keith, he manages over 100 Million in investor money. I know about 20 stock brokers, and Keith is the only one that makes money, the others just buy what is on the front page of the Wall Street Journal each day.

I called him up with Skype.com the other day checking in to see how he was doing after the recent economic problems.

He sent me this pivotal information.

Bangkok, Thailand
Wednesday, October 22, 2008

I thought this might be of interest to you……….the piece Stock Market Chaos Explained is worth the read. The repeal of the”Up Tick” rule has been proven to be a disaster.

Todd Writes;

All of us are concerned with our retirement accounts, our economy and the future of our country. I prepared the following summary so that each of us might better understand what is driving our stock prices down and why action is urgently needed by all of us. I predicted the demise of this market a year ago after the SEC repealed the Uptick Rule. For the longest time I thought I was missing something. Saturday morning Mr. Mike Huckabee went on Fox News and said that he has a credible source who believes that our markets are currently under terrorist attack. Last week, Mr. Duncan Niederauer, President of the NYSE said that he too felt we needed to reinstate the Uptick Rule. I believe the repeal of the Uptick Rule by the SEC is directly related to the massive declines in our markets this past year.

Please forward this email to your friends, family, coworkers and neighbors asking them to call their elected officials and candidates and stress the need to have an immediate public debate on this important issue. Nothing would make me happier than to be proven wrong. That would at least take the worst case scenerio off the table.

Thank you
Todd A. Spence
111 West Port Plaza
St Louis MO 63146

July 6, 2007, the Securities and Exchange Commission eliminated a rule that opened the door to financial terrorism, greed at the expense of the poor and enrich those in the world who stand to benefit most from our destruction.

This rule, the Uptick Rule was first enacted in 1938 to stabilize the stock markets. The last year to mirror our current stock market losses is 1937, the year prior to implementation of the Uptick Rule. To understand the purpose of this rule you must understand the minute by minute procedures that run our world financial markets. Simply put, the market has the following "kinds" of investors:
Longs (people who buy a stock and hope to sell it someday at a higher price) Shorts (people who sell stock they do not own with the hope of buying it back at a lower price)

If that seems abstract, just understand that a Long is an investor who has taken money from his account and has bought shares in a company hoping it will grow and prosper. Each of us who have a 401k plan are Long the market and Long the stock or stocks held in our retirement accounts. Shorts are people who sell shares they do not own with the hope (or careful analysis that leads them to believe) the company they are shorting will decline in value or maybe even go out of business. The absolute best return for a Short is the collapse of the company they have shorted. For example, had you shorted Bear Stearns at $160 a share your profit would've been $150 based on its "fire sale" price of $10 to JP Morgan. If you had bought Bear Stearns at $160 a share as an investment your loss would've been $150, again based on the "fire sale" price of $10.

Some will argue that the Shorts are terrible people for wanting and hoping companies to collapse so they can max out their profits. There are without a doubt those kinds of people in this world. However, a powerful market requires "players", lots and lots of "players" to create liquidity.

Liquidity leads to accurate pricing. Think of it this way, if 1000 people think your house is worth $50,000 and 2 people think your house is worth $100,000 then your house is probably worth $50,000. On the other hand, if only 2 people look at your house and one thinks the house is worth $50,000 and the other thinks the house is worth $100,000 then true price discovery is quite difficult. Clearly the "more people" option provides a more believable price. It is that premise that creates liquid markets. Having people playing it both ways simply creates more liquidity and therefore more accurate price discovery.
The Uptick Rule, first enacted in 1938 to provide greater stability to our markets, is simple in its purpose. Anyone wishing to short a stock would have to wait until someone bought the stock at a slightly higher price. This would create an Uptick and allow someone to come in and short the stock.

This simple rule provided a degree of protection for our markets. People could not group up and overwhelm a stock by shorting it over and over and over again and driving the price to $0.00. The Uptick Rule would not eliminate the chances of a company going to $0.00 but it would at least be an orderly process.

Elimination of the rule has at least in part been responsible for stock market losses around the world, a housing collapse here at home, the growing chances of recession and a death blow to our financial institutions. Efforts by some to encourage the SEC to reinstate this rule have fallen on deaf ears and, last week, the SEC firmly rejected any thoughts of bringing this rule back. I strongly disagree with that decision and believe that we are either under attack currently or have certainly paved the way for such an attack.

By removing the Uptick Rule the SEC has made it completely legal to line up and short companies over and over until the company collapses. As an added bonus, the rewards to the shorts are potentially billions and billions of dollars in profits. To us, the investors, it means a complete loss of our hard earned invested dollars and potentially the collapse of our economy.

Remember, this is now absolutely legal as defined by the Securities and Exchange Commission.

So how can this happen? All you need is a target and a catalyst. Lets use Bear Stearns as our example. Lets assume that a managed fund within Bear Stearns blows up. The company is required to make this information public immediately. Upon release of this data the following would likely occur on some level. People owning stock in Bear Stearns might decide to sell a portion of their stock to reduce risk. This would cause the price of the stock to fall as sellers would be more active than buyers. After all, who wants to invest in a company who just announced an internal accounting problem that could potentially lead to investor losses. In the period from
1938 to 2007 the Shorts would have to wait on the sidelines while this price dropped. At some point, buyers would return to the market looking for a bargain and a "new" price for the company would be established. It was at this time that the Shorts could begin to trade. Without the Uptick Rule, the sellers can be joined by the shorts adding increased selling pressure that would eventually drive the stock price to collapse. True price discovery is lost when you have an abundance of sellers but no buyers.

Think of it as an avalanche. At first a few flakes of snow blow down the mountain (sellers) and the hikers (buyers) coming up the mountain can easily advance against the snow. Add in more and more flakes (shorts) and the snow begins to overwhelm the hikers eventually driving them down the mountain leaving nothing in its path but death and destruction. The Uptick rule simply slowed the process by allowing the hikers (buyers) to right themselves before releasing more snow (shorts) down the mountain. The elimination of the Uptick Rule simply leaves the people on the mountain without an escape route and no time to develop a plan to counter the attack.
Bear Stearns was a 100 year old company that survived two world wars, the great depression, Y2K, two gulf wars, terrorist attacks on the World Trade Center and countless recessions and slow downs. It could not however survive one year without the Uptick Rule.
As I stated earlier, you need a target and a catalyst. Enter the housing crisis & FASB Rule 157. After 9/11 our country and our economy took quite a hit. To combat this the Federal Reserve lowered interest rates to stimulate commerce. This allowed more and more Americans to buy real estate and buy they did. In parts of the country people actually lined up to place purchase contracts on houses and condos. Some bought to live in their house, some bought to rent their house and still others bought to flip their house. Some people bought two houses to flip, some bought 20. In the end we had an inventory problem. We built more houses and condos then we needed and thus price discovery became quite difficult. For many reasons, people began to default on contracts and mortgages and this excess inventory began to flood the markets driving prices down further. Instead of dealing with the front end of the problem (inventory) we concentrated on the back of the problem (foreclosures). The best way to combat foreclosures is to reduce inventory, not the other way around.

Even with all its problems, the housing market was not the catalyst. That distinction falls on the SEC decision to implement FASB Rule 157, Mark to Market. Another careless rule change, FASB Rule 157 required businesses to adjust asset values to immediately reflect available market prices regardless of circumstance. This decision would have an enormous impact on our housing prices, our stock markets and would eventually wipe out many of our financial institutions.

To illustrate Mark to Market consider a new subdivision of 10 homes, each sold to the original owner for $100,000. Later, one owner is forced into a "fire sale" event. Maybe a job loss, maybe a divorce, maybe a death in the family. Unable to find a quality buyer the house sells for $60,000. FASB Rule 157 would require each homeowner in the subdivision to take an immediate loss on their personal financial statement of $40,000. Regardless of whether they wish to sell their house or stay in their house for the next 50 years. FASB Rule 157 basically says "adjust it, adjust it now". This rule has led our financial institutions to literally write off hundreds of billions of dollars in United States of America real estate. It says you must recognize these losses in their entirety even though you really haven't actually lost anything. The flip side of this coin is that if the next house sells for $100,000 (the original purchase price) then you would need to report $40,000 in gains! In a world where investors demand stable and predictable earnings, this rule eliminates any possibility of stable, predictable earnings. Mark to Market would serve as the perfect catalyst to this crisis.

With the targets identified (the banks, the investment bankers, the Bear Stearns of the world) the process would begin. Start by shorting Bear Stearns over and over again. When the Longs start to panic and sell the shorts step in behind them and short the stock some more. When the margin calls kick in the selling really picks up speed allowing the shorts to follow that with additional selling driving the price lower and lower. With the price plummeting the company is unable to quickly defend itself against the avalanche of selling. At the last moment, the Federal Reserve steps in and brokers a deal at $10 to JP Morgan. The investors are wiped out, the Shorts make a fortune! People have made billions of dollars this past year using this strategy. Billions of dollars. Next up, Lehman Brothers.

The process repeats itself over and over. Bad news starts the selling, the shorts kick in driving the stock price down, the company unable to defend itself falls to the brink of collapse. Long term investors start selling in panic driving the stock price down further only to be joined again by the shorts. This has been the reality of our stock market under the watchful eyes of the SEC. Stability in the marketplace has been replaced by relentless volatility shaking the confidence of investors representing the very stable players of teachers unions, employee pension funds and 401k accounts.

This relentless selling would soon spill over into various computerized trading programs around the world. As certain market milestones are breached the selling would pick up and intensify. Any attempts to buy the market in support of prices would be weak, limited and met with additional selling pressure pushing the markets to lower lows. Finally this selling eventually leads to the kinds of margin calls we witnessed last week that serves to wash out the final hopes.

This volatility saps the confidence of our investor class. After all, how does one prepare for retirement or a new home purchase when the value of their investments feels to be in constant decline. How does one buy a new car after seeing their investment portfolio crashing in value. As a nation I believe we can handle losses in the stock market as long as our real estate market is stable. I also believe we can handles losses in our housing prices if our stock market is stable. I do not believe we can prosper with drastic reductions in both asset classes simultaneously. In order for us to make large purchase decisions we must have some degree of stability in our investments and confidence in our future. This fear, this lack of confidence has pushed home buyers to the sidelines afraid to make major
investments until the markets stabilize. Auto dealers, furniture stores and shopping malls will begin to see big ticket sales slow as people grapple with years of investment earnings wiped out in months.
I never imagined it would go this far or this long.

Statistically, this has been the absolute worst year to invest in our country in its history. The numbers are staggering. Most of our companies have lost 50% of their value in the last 12 months. This market is priced for absolute disaster. Ironically, our economy is not yet in recession, our unemployment is not in double digits, our productivity is not tanking, our energy prices are not out of line with those from around the world. I can go on and on, but the bottom line is this is a self imposed crisis. This is a self imposed recession. This is a self imposed housing crash. We've put the tools of our demise into the hands of the people who most want to hurt us.

And in our destruction lies their profits. Obscene profits. Our retirement accounts.

Franklin D Roosevelt and his administration responded to the turbulent markets of 1937 by implementing the Uptick Rule to protect and stabilize our markets, our companies and our investors. The current Administration decided to eliminate these protections. For what its worth, I'd rather put my money on FDR.


The above analysis misses a few additional catalysts, like the ability of the short sellers to buy Credit Default Swaps on the companies they target. It would be like being able to buy a life insurance policy on a random individual and then to participate in somehow ending that person’s life to collect. Credit default swaps were bought aggressively on Lehman well before the short sellers drove them out of business, then once in bankruptcy the credit default swaps paid off over 400 billion (last Friday Oct. 10th) to those who placed the bets.

Another important point is the attack by the short sellers when it becomes apparent that the company needs to raise capital. If a bank needs to sell stock to raise capital due to the Mark to Market accounting, the shorts would sell the stock down to fast and thus steal that capital and make it impossible (too dilutive and expensive) to raise capital, thus resulting in Asset Sales…..and then more distressed selling which then triggered more Mark to Market accounting adjustments…..a perfect Storm and a vicious attack on our financial system. All at the hand of the SEC and Christopher Cox. He has proven to be the worst chairman in history, and his stubbornness to reinstate the uptick rule or even discuss the merits is unconscionable.


Please be an advocate and pressure any elected official to act on this

Up Tick Rule and the Stock Market Short Avalanche