According to a recent Wall Street Journal article, the SEC is being deluged with letters supporting the return of the uptick rule. Pressure for the rule has been building since the market melt-down last fall, generating additional interest this spring (see previous post). Let me state upfront that I believe when regulators interfere with the natural flow of the market, as they did when banning the short selling of financial stocks last fall, it does more harm than good - primarily by reducing market efficiency and increasing volatility when temporary restrictions are lifted. Besides the irony of helping to reduce risk management opportunities, adding an uptick rule seems ineffective for liquid markets, for which it is not all that hard to find a plus tick. Nonetheless, I understand and appreciate the arguments on both sides - primarily that we did fine with it for near 70 years. I am also not sure it will make much difference one way or another. Yet the current debate seems to expand the argument, and fall into the trap of assuming correlation implies causation. This is apparent in the following quote:

"Isn't it coincidental that right at the time the uptick rule was abolished, the sharp spiral downturn started."
While we can debate whether the market began falling July 6, 2007, or later that year, does it really matter? Could it also be argued that the rule was artificially propping up a market that should have long since fallen under the weight of a housing bubble? Is it the rule change that caused the market to crash, or did it simply get out of the way of the inevitable pent-up selling? Is there any difference? Was something else at play? One current argument goes on to say that not only should the uptick rule come back, but that naked short selling should be banned, capital ratios should be increased, the CDS market should be regulated, and leveraged ETFs should be examined. All worth examining. But if the CDS market becomes more regulated (a near given), current naked short selling rules are enforced (not such a given), and leveraged ETFs are restricted, is the uptick rule even necessary? Should we require a little more evidence?

As an additional reason for changing the rule, another advisor mentions that the repeal of the rule "drastically changed the outcome of many stocks this past year." Last I saw, so did greedy banks and home owners, yet we seem to be forgiving many of their problems, and even making it easier for them to become whole, but I digress. Yes, when bad companies are sold, they tend to go down. Maybe the market needed to drastically change. Was there overshooting, sure, but markets have a tendency to overshoot, in both directions.

Maybe the real point of contention is given by another advisor quoted in the article, stressing that reinstating the rule will help "investor psychology." Possibly, but is this a reason for bringing the rule back? And which investors are they talking about? Will the psychology of short-sellers or hedge funds be better off? Probably not, and maybe that is the point. Many blame the hedge funds and short sellers specifically for destroying their nest eggs. It only seems natural to want to punish them, but does it solve the problem? Once again, I don't think it does.

We have to be careful when assuming that one thing causes (or doesn't cause) something else. In fact, I know that some will argued that I am falling into the same trap. I agree. In fact, that is the point. When we interfere with and observe one outcome or property, and try to describe what we are seeing, the less we know about the other paired property, not unlike what Hiesenberg observed over 80 years ago. Controlled studies are needed, but as with quantum physics, this is difficult for dynamic markets. Maybe the next time the markets begin to fall we should spend less time assuming it is only caused by a structural flaw in the system, and more time understanding if something fundamental to the market started the selling. The market may be telling us something early on. If we had listen a little earlier, maybe we would be months and years into the next recovery ....... and figuring out when and how to short the next bubble (which if the uptick rule is reinstated, may be more inevitable).