Now that the Dow Jones recently hit 10,500 and is on target to hit 11,000 or so by March 2010 (if the current uptrend continues), it’s hard to believe we are 4,000 points or so off the low set in March 2009 of 6,440. The market has certainly snapped back a bit. And many credit the economic stimulus package and bank bail outs for stopping the markets free fall, myself included. But either way, it was a hell of a price to pay for what some believe to have caused the collapse in the first place. That was the SEC’s decision to repeal the Uptick Rule on July 6, 2007.
The Uptick Rule was created in 1937 in order to prevent short sellers from overwhelming an already falling market, and causing it to crash. The rule said that you could only short sell a stock after the price ticked higher than the previous sale. What’s important about that was it gave market makers the ability to stop a falling stock at some point on the “downticks”. Only traders holding a long position could sell on the downticks. With this rule removed however, short sellers now have the ability to force a stocks price down through these lines of defence. This is a very dangerous thing, because stocks can fall harder and faster than they can rise. The bottom line is short sellers now have an advantage over the other market players in these situations. So lets take a look at the chart above and see if there’s evidence to back up what I’m saying here. The arrow on the chart points to the day when the Uptick Rule was repealed. Within a week or so from the day it was repealed, the Dow Jones spikes up about 500 points to hit 14,000 for the first time ever. Only to reverse the following day, however. This formed the “left” shoulder in the Head and Shoulders reversal pattern that followed. From there the Dow drops 1500 points or so within 4 weeks before making a second attempt a 14,000 two months later. All in all, it took about 6 months from the day the Uptick Rule was repealed to complete the head and shoulders reversal pattern. But what really stands out when you look at this chart closely, is the texture of the bars to the right of the arrow compared to the bars to the left of the arrow. For those who don’t know what I’m talking about here, each bar on the chart represents a days trading. The bars I have circled are days in which the markets sold off climatically with short covering rallies that followed. But in general, all of the bars to the right of the arrow are much longer and more erratic then to those on the left. It’s immediately following the repeal of the Uptick Rule that the Dow begins these 200-300 point daily swings back and forth. The bars to the left of the arrow are tight and compact, and clearly represent a more stable trading environment. So why bring this up now? The market has clearly reversed and for now is rising at a pretty good clip. Well, sooner or later this market will stall again. And if this rule has not been reinstated by then, we face the same kind of catastrophic selling that occurred in 2008. And if that happens, who’s going to come up with the next trillion dollars to keep the country from going into a great depression? It seems to me a pretty cheap insurance policy would be to reinstate the Uptick Rule.