The stock market finished the week on an upward path with the Dow ending the day (03/13/2009) at +53.92 (7223.98). From my perspective there has been a multitude of confusion about actually what comprises “The Market”, and that includes everybody from the guy on the street to the President. One thing is certain that the SECOND most powerful controlling entity in the United States is the Stock Market. Follow me below the fold and I will lay out my perspective of what actual constitutes the “Market”.
Currently in the minds of most Americans the “Market” is composed of a gigantic pot containing all businesses, banks, insurance companies, domestic auto manufacturers, investment houses, Drug companies, airlines, and mining companies. I may have left out a few sectors and industries, but you get the idea. As a preamble it is necessary to present some of the basics of investment and trading in order to highlight the differences between the two.
The stock market consists of only two significant components, INVESTORS and TRADERS. These are the two forces in the market that must be balanced out. This is contrary to popular belief that says market balance must be maintained between BUYERS and SELLERS. Buying and selling are simply market activities that are executed AFTER you have decided whether you will be a long term investor or a short term trader. Buying and selling activities must be balanced when the market is running normally. However more importantly, in order to maintain LIQUIDITY balance in the market there must be an adequate supply of both investors and traders actively involved in the market. Both types of marketers bring their own unique but absolutely NECESSARY form of liquidity to the market. It is the wholesome flow of this balanced liquidity that creates a healthy market environment.
A few more basic definitions are in order to provide clarity to my arguments, Simply put, investors are the folks who follow the traditional methodology that is based on the practice of “buy and hold” of equities. Specifically in this instance since I am talking about the stock market, the practice mandates the purchase of company stocks with the expectation that the value of the chosen stocks will INCREASE over time. Investors make their purchase selections based on the “Fundamentals” of companies, which roughly defines the following characteristics of each company of interest, namely its viability, competitiveness, its products, and its prospects for long term growth.
On the other hand the trader is not concerned about company fundamentals to the same degree as the investor. Rather, the trader is primarily interested in the data documenting the behavior of a stock’s price and volume movement over various milestone periods (20 day, 50 day and 200 day) in the market place. The trader has a vast array of mathematical formulas to run against the stored performance data, the results of which will be used to drive their purchase decisions.
It should also be mentioned that both the investor and the trader also have another market tool available that can be used to enhance and secure their respective market position strategies. This extremely popular tool is called OPTIONS. Again I won’t go into the vast number of technical configurations that are available for the utilization of options in the stock market. It suffices to say that options may be simply defined as follows. A stock option is an market instrument of transaction in which the underlier is the common stock of a corporation, giving the holder the right to buy or sell its stock, at a specified price, by a specific date.
Ok, what has this to do with the problems of the market? Well, let’s assume that I’m a traditional successful investor and I have been active in the market at least until the late fall of 2007. At this time I noticed a disturbing trend taking place in the stock market. Good, solid companies were steadily losing the value of their shares, even in the face of excellent performance and strong fundamentals. Upon further investigation I come to the conclusion that a growing army of traders acting as short sellers are DRIVING the prices of a broad array of stocks in many sectors down toward zero. Since I’m a smart investor, and not a trader, I move a significant portion of my capital from stocks into more protective cash preservation positions. I might even have found some more attractive stocks in the new emerging markets for this period of time. As we moved further into 2008, my concern turns to alarm as widespread selling pressure began to dominate the market. This anxiety causes me to decide to get out of the stock market altogether and wait on the sidelines with my funds isolated from all action in the stock market.
Traders, on the other hand, use a variety of techniques to make money on any market move either up or down. Since they have this flexibility, they don’t particularly care whether the market goes up or goes down. If the general trend of the market is downward or losing value, this is defined as a bearish or selling market and traders simply “short” stocks to make money.
Here is a quick description of shorting. Shorting a stock means to sell it first then buy it back after the market (or that stock in particular) goes down. Short sells are bearish on the market; believing that the market will be going down and as such, they can make money by “shorting”. Sell first, buy back later at a lower cost, hence the profit is made from the difference between what the price of the stock was when you originally “sold” it and the (lower) prices that you actually buy it back later on. In order to do this transaction the short seller MUST BORROW the stock from someone (generally a broker), to whom he/she will pay later on. Now this point is VERY IMPORTANT! The broker (or agency) that the short seller borrows the stocks from MUST actually have ownership of the number of stocks requested in their possession. If the broker agrees to a standard short sale without possessing ownership of the stock it is illegal on the broker’s behalf.
Also the trader can place a so-called NAKED SHORT sale, which is a transaction wherein the trader assumes full responsibility for providing the stocks to successful buyer of the short. Under these conditions the trader’s risk is unlimited as the stock can theoretically rise to any value. Naked shorts are considered high risk because if the value of the stock goes up, the trader MUST “cover the short” by buying the stock at an even higher price. However, naked short sellers dominated the current “over sold” market and were instrumental in the massive stock market sell off that we have been observing for the past six months.
The restoration of confidence in the stock market that Treasury Secretary Paulson was calling for was basically a prayerful plea for investors to get back into the market and provide that LONG TERM liquidity that only “Buy and Hold” investing can bring to the equity market. Unfortunately, the investors stayed on the sidelines.
Enter Congressman Barney Frank, who day before yesterday called for a revamp of the SEC trading rules for the stock market, in particular restoration of the “Uptick Rule”. Here is definition of the Uptick rule and its significance from Investopedia.com.
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What Does Uptick Rule Mean?
A former rule established by the SEC that requires that every short sale transaction be entered at a price that is higher than the price of the previous trade. This rule was introduced in the Securities Exchange Act of 1934 as Rule 10a-1 and was implemented in 1938. The uptick rule prevents short sellers from adding to the downward momentum when the price of an asset is already experiencing sharp declines.
The SEC eliminated the rule on July 6, 2007, but in March of 2009, following a conversation with SEC Chair Mary Schapiro, Rep. Barney Frank of the House Financial Services Committee said that the rule could be restored. Frank’s conversations were spurred by a call for the return of the rule by several members of Congress and legislation reintroduced on January 9, 2009, for its reinstatement.
The uptick rule is also known as the “plus tick rule”.
Investopedia explains Uptick Rule
By entering a short sale order with a price above the current bid, a short seller ensures that his or her order is filled on an uptick. The uptick rule is disregarded when trading some types of financial instruments such as futures, single stock futures, currencies or market ETFs such as the QQQQ or SPDRs. These instruments can be shorted on a downtick because they are highly liquid and have enough buyers willing to enter into a long position, ensuring that the price will rarely be driven to unjustifiably low levels.
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The market’s recent bullish moves have been spurred on by investors seeing that Congress intends to provide some protection for long term “Buy and Hold” investors against the ravages of an unchecked short sellers market. Rest assured that once investors return to the market, one of the major problems currently facing this country, the availability of liquidity in the stock market and thereby for business, will have been resolved. That is why we need to keep urging Barney Frank to keep on keeping on!
