The Butterfly Effect and the Uptick Rule
by: Michael Albert
Seeking Alpha: July 18, 2008
{I post this not as a fully developed argument nor as an addition or counterpoint to The Black Swan (or to 'The Law of Unintended Consequences' in general) albeit none of these elaborate(d) theses 'explain' what is happening or generally pose testable hypotheses, but, I suppose, to help us in one way or another to thimk it thru & to which I will add my few poor thoughts.}
The butterfly effect has always been an interesting concept to me. The notion is rooted in chaos theory, and argues that small variations in initial conditions can cause massive differences in a final event. In other words, in a dynamic system (example: the stock market), any change, no matter how small, can result in completely unpredictable behavior. Thus, a butterfly flapping its wings (a small event) can cause a tornado in some part of the world (a massive event).
How does this apply to the stock market? Markets certainly exhibit erratic behavior, and it is not unusual that seemingly minor news can cause volatility to spike not just for a particular company's stock, but its industry, and perhaps the broader averages, such as the Dow Jones Industrial Average, or the S&P 500 Index. I pose the following question: was there anything in particular that happened to the structure of the market which may have had a butterfly effect on the price behavior of all stocks?
I think many would argue that the removal of the Uptick Rule by the SEC in July of 2007 (which "by coincidence" also marked the start of much of the current financial turmoil) was a relatively small event. After all, short selling makes markets more efficientand the uptick rule was an artificial barrier to freely betting on a price decline.
Let's revisit the concept: the butterfly effect is what happens when a small change causes a massive difference in your final output. Could the removal of the Uptick Rule have resulted in a massive change to market behavior? From a Behavioral Finance standpoint, it is entirely possible. Fear of losing a dollar hurts twice as much as the happiness of making one. In other words, there is an asymmetry to emotion, whereby fear, which can cause market declines, is far more powerful than hope, which can cause market advances.
The Uptick Rule was essentially a barrier to fear, preventing trading from collectively forcing down a stock price that is already declining, and lessening the impact of a potential self-fulfilling prophecy of declines. Without the Uptick Rule, declines can potentially become much more severe, and have very real consequences on a company's fundamentals. Why? Don't bondholders watch equity prices? Don't suppliers and customers?
If you still think the removal of the Uptick Rule is such a small change to the structure of the market that it couldn't possibly have resulted, at least to some extent, in the mess we're in right now, then let's consider its history for a moment. The Uptick Rule was implemented by the Securities Exchange Act of 1934, meaning that it has been in place for more than 70 years. It was effectively created in response to the stock market crash of 1929, which marked the beginning of the Great Depression.
Suddenly, as of July 2007, when the Uptick Rule (i.e. the butterfly) was struck down, allowing shorting on declines to occur freely without any barrier to irrational fear, the behavior of financial markets changed dramatically to a state of extreme volatility (i.e., the tornado).
Is it possible, then, that some of the problems we are experiencing in the markets now are a result of the butterfly effect? Could that have been the minor change which resulted in our current brave new world of volatility?
Myself, ie grandpatb, I would demur from the 'efficient short thesis' if the author included naked shorting(NSS) & Failure To Deliver(FTD) w/i the thesis. Further, I would add that the huge increase in FTDs would support the notion I have sometimes suggested that there is indeed communication among traders (hedge fund or individuals) whose agents are located a short distance from the exchanges & who can generate huge nos. of sales in 100 units back & forth among each other virtually in the blink of an eye driving equity pps virtually at will in the absence of 'gorillas' on the other side of the trades.
The elevation of C. Cox to SEC chief & the drop of the uptick rule were not a matter of mkt efficiency so much as a matter of convenience to which the regulators then turned a blind eye until their insatiable greed brought down the house of cards that is our credit system.
It is no coincidence that our $ is stamped with 'In God We Trust'. The brilliance of Alexander Hamilton & the good gov't of George Washington in appointing AH to the chagrin of Thomas Jefferson was the new understanding of the mkts in an expanding commercial worldwide universe which depended on creditworthiness.
The INSATIABLE GREED of the current actors have brought this system to near unfathomable ruin. And then Jim Cramer goes on CNBC & wails: Ben Bernanke save us, save us or ######. Save us from the chaos I & my HF buddies & idiot L. Kudlow & sell-out C. Cox & Phil Gramm (of I'm-the best-friend-you-corporate-chiefs-have fame & Americans-are-whiners fame) brought us all the EL GRANDE BUTTERFLY EFFECT. Of which the destruction of the international credit system is the unintended consequence. Chaos ensued but it was no accident. It stems from willful theft & alotta closed or winking eyes IMHO.
AI
