Tuesday, March 10, 2009

We Need The Plus-Tick Rule, Part I

The plus-tick rule should be reinstated. Short-selling, where regulated by the existence of such rules, is a valuable component of well-developed capital markets. It adds liquidity by adding offer-side depth and encourages critical thinking by allowing for a way to profit by being bearish.

Short-selling without a plus-tick rule, however, not only takes liquidity out of the market by diminishing bid-side depth, it actually promotes behavioral factors which tend to diminish critical thought.

The rule addresses fundamental investment return asymmetries caused by permanent emotional and structural biases in the market. Contrary to arguments made in support of its elimination, its continued existence is more critically important today than it was a generation ago. Technological advancements which have in many ways been very good for the market have also made return asymmetries even more lopsided.

Further, these technological advancements have significantly weakened protections against other destabilizing factors that diminish market integrity, such as inaccurate or improper information dissemination and the use of excessive leverage. The plus-tick rule is an indirect but very effective antidote for these as well.

The capital markets exist so that growing enterprises may access capital, pay for the privilege of getting it and allow investors to account for their own liquidity needs without necessarily limiting those of the enterprises accessing the capital. The current system, which is continually evolving, is the best yet discovered which harnesses the power of the profit motive in a positive way while restraining some of its destructive extremes. The evolution of the capital markets is a dialectic, a never-ending process of trial-and-error which careens between "not enough" and "too much" while passing "just right" and spending most of the time in that middle area.

To that point, it doesn't matter that the mistake of removing the rule was made: We now have dramatic evidence that bad things happened in its absence. I will make the case in Part 2 that there is even more to the story

Again, making the mistake of eliminating the rule is nothing, as long as we learn and reinstate it immediately.

Many of us watched firsthand the destruction caused by the practice known as portfolio insurance in 1987, when a structural bias enabled by emerging strategies and technologies caused a dislocation between futures and underlying prices which could have been profitably exploited by those in a position to do so until price levels reached zero. Then as now, it was difficult for the market participants and regulators to get a grasp on the effects of unintended consequences.

An obvious point with respect to the 1987 crash is that the rule was in existence at the time. Although the developing options market provided a way to avoid the rule that was far less ubiquitous a generation prior, I am not arguing that the rule is a panacea, or even that there won't be clever ways devised to get around it. Rather, it is a powerful tool that can be brought to bear upon a large part of the market, and that, along with other factors, helps maintain balance. Now as then, the answer lies in controlling extreme behavior.

Reinstating the rule will be relatively easy to accomplish, it addresses permanent as well as short-term problems, and it will help alleviate problems for which more direct remedies will take some time to implement. The reinstatement of the rule will in particular address imbalances that are unique to today's market, such as those outlined eloquently by Doug Kass, Eric Oberg and others. It will have more relative power today, even, than it might at another time.

This series of articles will have three parts.

The first will address the permanent and structural biases in the market for which the plus-tick rule provides the right counterbalance. There were actually a number of variations to the rule, the first and primary example of which was Rule 10a-1 under the Securities Exchange Act of 1934. I refer generically to the rule because the basic premise is shared across its variations.

The second part will discuss certain obscure but significant risks built into certain market practices such as basket trading and the use of leverage, and examine some of the unintended consequences of having eliminated the rule to the detriment of the original purpose of capital markets.

The third part will describe how the rule has been strengthened and weakened at different times over the past two decades, show how the market acted during those times, and describe the process whereby the rule was eliminated in July 2007.

Part 1

The plus-tick rule was conceived in 1934 to address the lack of balance between the effects of the active emotions fear and greed as they are applied in a marketplace where the majority of investors are owners of stocks. The rule requires that any person selling a stock short must do so only at the price which is the higher of the last two discrete transactions. This means the final trigger on a short-sale transaction must be pulled by a buyer eager enough to do so. This not only forces the seller into the passive role, but allows long sellers to make their sales ahead of short sellers. Today, in the absence of the rule, the short seller may initiate the transaction and compete with natural sellers.

In this way, the rule specifically addresses the effects of emotional behavior on market pricing. There are two primary and related reasons why the rule was applied to selling, rather than buying, stocks. First, although there are many exceptions to this general characteristic, stocks tend to go down faster than they go up. Second, many more stocks are owned than held as short positions, and that results in a permanent bias toward supply which may become available for sale.

Not only are existing investors motivated to sell a security or market that is either trending down or subject to sharp downside moves, new investors tend to stay away as well. Their risk appetite is diminished along with their confidence in any eventual return of, or on, their capital, so they keep that capital away from the market and from the enterprises that may need it.

News accounts last fall promoted the notion that because spreads are so thin now, the rule is irrelevant. This is a specious argument, as while the width of the spread may influence the relative willingness of a buyer to "step up" and take an offer or buy higher than the last sale which was initiated by a long seller, the actual transaction will not occur until the buyer has decided to complete it, proactively.

After all, there is asymmetry between the need to enter any investment position and the need to exit the same one. Going in, the choice is unforced. You can take the position or forget about the whole thing and go bowling. Once the position has been assumed, however, its disposal is a matter of timing only; the act of selling a long, or covering a short, is a foregone conclusion, with the only the future date and price unknown.

Further, any investment position must be monitored to some degree until it is gone. During periods of adverse price action, a person who has not yet taken any investment positions can usually just wait and see whether the price gets better. The person already in a position might also adopt such a stance, but with the very different awareness that when the price goes the wrong way, real money is being lost rather than opportunity. This awareness, evolved into fear, regret and other forms of anguish, can lead to poorly timed exit decisions. History has demonstrated that such negative emotions can be extremely infectious.

Across the whole market, more stocks are owned, or held long, for positive investment returns than are shorted for such profits. When overall market price action is adverse to owners of stocks, more of them are forced to sell than are forced to buy when the price action is adverse to those who are short. There are just more people in long positions to be forced out when things go against them than there are people in short positions who get forced to buy when stocks go up.

This return asymmetry has a detrimental effect beyond what happens to investor wealth. As the security at the bottom of the balance sheet, common stock represents not only permanent capital but also the most sensitive, continuously priced and ubiquitous indicator of a company's fortunes. A rapidly declining stock price can very quickly not just distract management but also begin to limit managers' ability to accomplish financial and strategic operating objectives, creating a vicious downward spiral of cause and effect which can easily threaten the company's existence as a going concern.

There are other less obvious issues and exacerbating influences on these negative effects. As stocks go down, especially into the single digits, a given absolute unit move -- say, a dollar -- in the price per share becomes a larger part of the value overall of the position. The absolute value percentage return for that one-unit move increases relative to that of the return for that unit move when the stock had a higher price per share. This is just math, but it matters because of its effect on the shares' liquidity.

Transaction costs and other market-impact costs are generally not only fixed or not highly correlated to the share price change but also are mostly fixed per share, rather than per transaction. As a proportion of a given position size, they actually increase as share prices decrease and the number of shares required for a given position size increases.

This tends to put upward pressure on market impact costs, attenuating liquidity and increasing volatility, therefore lowering the likelihood that the marginal long-term holder will continue to be willing to stay in the stock, and so adding to potential selling pressure. Share ownership becomes redistributed to more speculative or potentially "weaker" hands, and so on. Finally, share-price limit rules at many institutions and stock exchanges and margin-lending rules related to share prices create additional selling pressure, while reducing the number of potential new investors and available investment capital as those price limits are broached.

The plus-tick rule was a reasonable single-factor counterbalance to these effects. By forcing the short seller to sit on the offer and wait for execution, it adds liquidity to the system. Because under the rule, short sellers are forced to be passive, it holds back supply when bids are disappearing, so acting as a circuit breaker when market action, or the action in an individual stock, becomes so frenetic that there is no time for information to be well disseminated so that cooler heads may prevail.

1 comment:

Winslow said...

It would be nice to include the credit for this article. It was written by William Furber, Managing Partner of High Street Advisors, LP. The Article was first published on TheStreet.com this morning, and referenced by Jim Cramer on RealMoney Silver