August 23, 2009
It is my belief that an alternative uptick rule is a bad idea. I consider myself to be a long term investor who believes in a buy and hold strategy. However, active traders who short equities have provided a great service to long term investors. Active trading has allowed people like myself to obtain substantial pricing discounts and other useful tools from brokerages. Online brokers have been able to offer low commissions as a result of having an active trading client base. An alternative uptick rule has the ability to harm active traders, which will impact the business models of online brokers. After reading over the noise made through the comments, I felt an obligation to share a different side. People who believe that the market fell from short selling are wrong. The fall was simply a supply and demand imbalance due to a failing financial system that was built up on mortgages that defaulted. In the letter to follow, I will use empirical data to back up my points.
Short selling does not affect the long term price of a stock. The long term price of a stock is determined by the growth and strategy of the underlying company. If a company continues to grow and implement a successful strategy, then the value of a company will increase with the price of the stock. I will use Microsoft and Apple as an example that supports this theory. At the end of August 21, 2000, Apple was at $50.50 and Microsoft was at $70.62. From then to August 21, 2009, both companies had a 2 for 1 stock split. Apple is now $169.22 and Microsoft is $24.41. If I would have bought Apple at the peak before the previous recession and the current one, then I would still have made a decent amount of money. I would not have made money with Microsoft. The reasons for the results are growth and strategy. Apple continued to grow by entering the portable music and smart phone markets. Microsoft has not found substantial markets to grow and has a strategy that focuses on changing the display of the Windows operating system. If short selling could damage the market, then I could not have made money with Apple. I do know that Apple is a very popular trade on both sides with active traders and hedge funds.
The people who have made comments supporting an uptick rule seem to be irrational in their complaints. Stories of people losing their retirement money and crooks on Wall Street stealing from them seem to be unwarranted. They are looking for a scapegoat, which short sellers fit, since they profit when markets fall. Markets go through cycles, which are created by short term events. Some days the market will be up and other days the market will be down, but in the end it will continue to rise as businesses continue to grow. Long term investors should not care about the short term because choosing the right investments will lead to great rewards. To place more rules on short selling will not change the behaviors of people. Naked short selling has been banned by the SEC, which is not noticed by the people making comments on this proposed rule. Placing more restrictions on short selling will therefore not boost confidence, since people do not realize that naked short selling has been banned. People will just look for another scapegoat the next time the market falls, which is inevitable.
The reason for the recent fall in the stock market can be attributed to mortgage defaults. It was widely reported that the world financial system would fail. The financial services companies that were main players in the financial system had vast quantities of products related to mortgages of poor quality. These companies took huge losses as a result of poor investment decisions relating to mortgage products. When the main players in the financial markets fail and look like they will fail, people will start to panic.
The panic created a supply and demand imbalance for all securities. If there is more supply than demand, then to sell a security the price must be lowered to attract a buyer. The majority of the supply was from people trying to sell securities they owned before they lost their money. These people believed it would be a long term issue, so they wanted to sell. Short sellers had nothing to do with the substantial fall, which is demonstrated by my next example. On September 19, 2008, the SEC banned short selling on stocks of most financial services companies. I chose five large institutions that have paid back TARP. This demonstrates the effects of the ban on the stock prices of stronger financial companies. The day before the ban was September 18, 2008. On that day Morgan Stanley, Goldman Sachs, JP Morgan, BNY Mellon, and US Bancorp were at $22.55, 108, 40.30, 31.57, and 36.77. On October 8, 2008, the last day before the ban was lifted, those stock prices were at $16.80, 113, 39.30, 24.45, and 30.83. Four of the five stock prices were down, three companies had their stock price fall by around 20%. The only company whose stock price was slightly higher was Goldman Sachs, which as seen by their recent numbers is doing better than the others. Another example is the recent surge in the stock market from March. Short selling with no uptick rule presided over the market during this period. On March 9, 2009, the SP 500 was at 676.53. Since then, on August 21, 2009, the SP 500 is at 1026.13. This represents a 51.7% increase in the stock market without any uptick rule in place. An alternative uptick rule can not be justified by these results. The proposed rule only has the potential to harm the market.
The harm to the market will be felt by institutions and individuals who use and rely on active trading strategies for their business. Active trading strategies rely on short selling. An alternative uptick rule is considered by the SEC as being more restrictive on short selling. If the purposed rule is more restrictive, then it will affect active trading. I believe short selling is a legitimate way to make money in the market. Long term investors have benefited from active traders through lower commissions and better tools brought about by online brokers. Online brokerages rely heavily on the fees generated by active traders. These lower commissions have brought down fees at traditional brokerages through increased competition. Online brokers also provide tools that have helped me make better investment decisions on my own without the assistance of a financial advisor. I do not believe that online brokerages would survive without an active trading client base.
I believe that the markets are better off without the increased regulation from the purposed alternative uptick rule. It is a bad idea with many consequences. The data that I have provided in my letter shows of no ability for short sellers to drive down stock prices or hurt investor confidence. Rather short sellers are a scapegoat for those in society who have made irrational decisions in regards to their investments. The purposed rule seems excessive and driven by political motivations. As a long term investor, I ask that you not implement an alternative uptick rule.