Trader’s Narrative

The SEC has recognized that the present rules for short selling haven’t worked out that well. It doesn’t take a genius to recognize that rampant naked short selling exacerbated the crisis, especially within the financial sector. The most egregious example is Bear Stearns but many other well known Wall St. investment banks saw their shares pummeled mercilessly late last year. As usual, the SEC is playing catchup. But if it acts intelligently it may still benefit everyone by creating a more stable, fair and balanced market.

As a consolation, any changes to the present rules won’t be sprung on traders as a surprise. We are presently in a 60 day consultation period, after which when or if a decision is made, it will be implemented after 3 more months to give everyone involved plenty of time to prepare. There are five possible options:

The first suggestion is to bring back the uptick rule that we have known so well over the past 70+ years. This was implemented in 1937 as a result of rampant manipulation of the market by wealthy speculators (the precursors to hedge funds) during the roaring 1920’s. It was eliminated July 3rd 2007 with little fanfare; The Uptick Rule: Nice Knowing You.

The disadvantage with the uptick rule was that it was easily circumvented by those that count. That is pro traders, institutions, etc. As always, in the end, the retail trader was left out in the cold while those with insider knowledge and more resources simply side-step the rules and sold short despite the uptick provision. Another disadvantage is that the market has become faster and more fragmented so it is getting harder to determine what exactly the immediate last price was. The advantage is that the uptick rule is well known to all market participants and it would be psychologically easy to simply revert back to them (or circumvent them, depending on who you are).

The second suggestion is to slightly modify the old uptick rule by making it more stringent: a short sale could only take place if the stock price traded at least a penny higher than before. I’m not sure what this slight ratcheting up of conditions really accomplishes. I suppose we could say 2 cents, 5 cents, and so on. In the end we’re really talking about a similar restriction to the old uptick rule with the same advantages and disadvantages.

The third suggestion is to introduce a restriction in trading only if a stock price experiences a decline of, say, 10% in a day. The simplest of these “circuit breaker” type suggestions is a blanket ban on short selling a stock that falls 10% within a trading session. This would be similar to limit days in commodity markets. Although, under this condition, the stock price could very well continue to fall much further than 10% - it simply couldn’t be pushed by short sellers.

The fourth suggestion is to soften the circuit breaker idea by just re-introducing the uptick rule for the remainder of the day if a stock falls 10%. So rather than no short selling at all, you could sell a stock short as long as it met the uptick conditions.

The fifth suggestion is to introduce a “bid test” if a stock falls 10% (in a trading session). This would mean that a short sale could occur only if it takes place at the highest available bid and not just an uptick.

My hunch is that if the SEC goes with any of the circuit breaker ideas it will introduce them in staggered fashion rather than in one fell swoop. There are two main perspectives on this sort of thing: leave the market alone and to regulate heavily. I fall somewhere in the middle. The trick is that while we do need to interfere with the market, it has to be done intelligently and minimally.

I can’t understand those that want a completely free market. We are constantly interfering with the systems that we live in. We have laws (that are constantly changing and adapting), we have police and courts that react to our behaviors and actions, etc. How is the stock market different?

The problem is when regulation is done with a sledgehammer it becomes outright intervention, which is at best useless and at worst, disastrous. If the SEC takes this short selling restriction too far, it won’t stop the practice but simply force it to take place in different forms and in different places. For example through swaps or other unregulated dark corners of finance.

Take a look at the Karachi stock exchange chart below to see what happened when the government of Pakistan put an artificial floor on prices:

Obviously a government mandated floor for stock market prices doesn’t work. And recall how last year, the SEC along with the equivalent regulatory body in the UK (the FSA) halted short selling from September 19th to October 8th 2008. Although it originally covered mainly financial and bank stocks, it was quietly expanded to include other companies as well. In the end, it had really as much effect as standing in front of a runaway freight and yelling ‘STOP!’.

But that doesn’t mean that we should throw our hands up and do nothing. Everyone involved with the market knows that naked short selling is a problem. It shouldn’t be allowed because it undermines the integrity of the stock market. If the SEC can put a stop to the abusive short selling practices it would go a long way in restoring confidence in the stock market. That would be much more productive than ruminating about the minutia of short sale restrictions.

Here is the sentiment overview for this Easter shortened trading week:

AAII Sentiment
This week’s sentiment survey from the American Association of Individual Investors shows 44% bears and 36% bulls. That’s a 7 percentage point change from last week for both camps (a decrease for bulls and an increase for bears).

This is a welcome development because although the market (S&P 500) closed the week higher than it started, sentiment is actually less hopeful than it was. This is just one glimmer of contrarian sentiment and it is a shallow change (at only 7%) but still it is valid. At this point, we’ll take what we can.

Investors Intelligence
In contrast, the survey of newsletter editors conducted by ChartCraft shows little change from last week. Tuesday’s results show 36% bulls and 37.1% bears - putting the two sides equally at odds. In early March, we saw a somewhat polarized sentiment. But as the rally unfolded, both the optimists and pessimists have been slowly approaching each other.

Howard Ruff
The 25% rally this past month has brought out the experts. And for the most part they are now back to their talking points. Take for example, Howard Ruff. He’s decidedly bearish as usual and saying that the recent move is just a bear market rally. He’s looking for hyperinflation and a “toxic” stock market for the foreseeable future.

On the other hand, the spasmodic Jim Cramer has declared the “the depression is over”. Never mind that it was just a few months ago that he asked people to leave the market for the next 5 years. And even shorter still when he promised by a gentleman’s handshake that Mad Money will feature a more rational host. The worst is over! And it is time to become a roaring bull (again). Cue the soundboard. Increase the props department’s budget!

The lesson here is to recognize the inherent bias in every source and to recalibrate what they say based on that. There are very, very few who are as easily bears as bulls and rather than swayed by a bias, rely on evidence based market analysis.

Rydex Traders
Two weeks ago, I mentioned in a similar sentiment overview that the itchy triggered Rydex traders have stampeded to the bull’s side. To put it bluntly, these traders are too excited for their own good and are positioned as they were at previous tops.

ISEE Sentiment
The ISEE sentiment index, which measures retail option traders, showed a consistent level of optimism all throughout this shortened trading week. Although never reaching spike highs (of 200+), the call-put ratio was noteworthy for the elevated plateau it reached. Here are ratios for the equity only ISE sentiment:

• Monday — 169
• Tuesday — 170
• Wednesday — 167
• Thursday — 174

The last time the ISE index spent 4 consecutive days above 167 was late last year, just as the S&P 500 reached a peak in early January 2009.

Follow the link for an update on the CBOE put call ratio (equity only).

Uptick Rule
The SEC is putting out feelers for a change to the rules governing a short sale. It wasn’t that long ago that the uptick rule was removed but there is now a real possibility that either it will be reinstated or some similar protocols will be put in place. From a sentiment perspective, the important thing is what people think about the change. If enough think that it will be a positive, it will be, irrespective of whether it truly is. This is the crazy, self-fulfilling effect that the market can have on itself - in the short term. In the long term, reality always reasserts itself like a wave of ice cold water.

Market Breadth
Persevering readers will remember that we’ve looked at market breadth a number of ways this week. Here’s another: the simple 25 day moving average of the Nasdaq daily advance decline statistics.
Continue reading ‘Sentiment Overview: Week Of April 10th, 2009′

In this quiet, shortened trading week, something historic will happen. As of today, July 3rd 2007 the ‘uptick’ rule will be eliminated.

If you’re new to all this, the uptick rule limits how a trader can sell a stock short. The rule only allowed short selling when the last bid wasn’t lower than the previous inside bid (Nasdaq) or for the NYSE, an uptick or zero plus tick. The intention of the rule was to prevent someone leaning into a stock and just hammering away at every single bid.

This was a rule that came about after the public uproar over the great bear market of the late 1920’s. It has been in effect since the SEC Act of 1934. This act not only brought about sweeping changes to the US financial markets, it established the SEC as the defacto guardians entrusted with policing the hobbled stock market.

A lot of good was done in the SEC Act of 1934. Pretty much everything we are now familiar with, from IPO’s, annual reports, quarterly statements, etc. all are thanks to it. But I am glad the uptick rule was thrown away.

It’s not like it was really accomplishing anything. For a long, long time now people have been getting around it. First using ‘bullets’ (or married puts) and then using single stock futures. Thanks to the ever changing landscape and the indefatigable creativity on Wall Street the uptick rule became the vermiform appendix of the financial markets.

If you want the complete lowdown, read the SEC ruling in full (pdf)