Apr. 13, 2008 12:00 AM
The past nine months have been a gut-wrenching period for stock-market investors.
Since mid-2007, the Dow Jones industrial average has suffered more than 45 daily drops of at least 100 points. A volatility index tracked by the Chicago Board Options Exchange has been running 50 percent to more than 100 percent above where it stood early last year.
The nervousness has shown up in plunging consumer confidence and overall anxiety about the economy.
But you have to wonder: How much of all that turmoil was avoidable?
The stock market has lost ground for various reasons. Investors have had to contend with the real-estate slump, the credit crunch, a weak dollar, a looming recession, spiking oil prices and surprises like the Bear Stearns debacle.
But the downdrafts were magnified by the elimination of a somewhat-obscure rule that had prevented bear raids from getting out of hand. Now, hedge funds and other big institutional traders have a clear path to bet against stocks by selling them short. And that, critics say, causes more frequent and intense downdrafts.
"Since elimination of this rule, we have witnessed a dramatic increase in short selling and substantial market volatility," complained Rep. Michael Castle, R-Del., to the Securities and Exchange Commission. "It is important that we monitor closely any impact of unrestricted short selling."
Short selling is the opposite of what most people do when they enter the stock market. In a normal or "long" transaction, you buy shares, hope they appreciate, then sell them. With short selling, you first sell shares you don't own (borrowed from a broker) in hopes you can buy them for less later, completing the trade.
After years of a Depression-fed bear market, in which many stocks were beaten to a pulp by short sellers, the recently formed SEC devised a way to restrict this activity.
The regulation, adopted in 1938, was called the short-sale "uptick" rule. It didn't outlaw short selling but slowed it down. Under the rule, short sales essentially were allowed only when the preceding trade was made at a higher price, on an "uptick." The idea was to prevent cascading downward pressure on stocks that could lead to manipulation.
Yet the SEC last July abolished that restriction. The agency decided the markets had evolved sufficiently, with better regulatory oversight and transparency, to render the rule unnecessary.
The SEC cited advancements such as decimal pricing and the spread of fully automated markets as factors that discourage short sellers from trying to manipulate a stock's price.
The SEC also said eliminating the rule would make for more consistent global regulation and reduce the compliance costs borne by the brokerage industry.
But the decision was controversial and remains so.
"I thought it was a bad move to eliminate it when they did," said David Daughtrey of Copperwynd Financial in Scottsdale. "Volatility clearly has increased since last summer."
David Brady of Brady Investment Counsel in suburban Chicago, who warned about the prospect of rising volatility, remains critical of the decision.
"Absolutely it has contributed to volatility," he said. "We haven't seen a period like this with such wild gyrations in quite a while."
Brady, a University of Arizona graduate,
blames hedge funds for most short trades and wonders if regulators understand the impact on markets.
"I'm not a fan of a bunch of rules to regulate the markets, but we need some framework," he said.
A SEC spokesman said no change in the policy is in the works. That's too bad because repealing the rule, in retrospect, looks like it was a case of fixing something that wasn't broken - but now apparently is.