The Securities and Exchange Commission (SEC) is considering reinstating the “uptick rule” — a regulation the SEC implemented in 1938, whereby traders were prohibited from selling a stock short unless the sale was made on an uptick.

Essentially, it meant the stock had to move higher before it could be shorted or taken lower.

The objective of the regulation was to prevent short sellers from exerting unrelenting, concentrated selling pressure on a security, thereby driving the stock down without allowing buyers and sellers to establish pricing equilibrium.

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After a one-year test program of permitting short selling without the uptick on a select group of securities in 2004, the SEC eliminated the rule for all stocks on July 6, 2007. Great timing! The S&P 500 (SPX) hit a top three months later and has fallen victim to unrelenting selling pressure ever since.

The current political climate has every appearance of offering broad legislative support for this initiative. At a time when most people feel lousy about the market, is re-instating the uptick rule more about feeling good than substance?

Following the Earnings Path

Uptick or no uptick, stocks and the overall market follow earnings over time. Fourth-quarter 2008 earnings for S&P 500 companies, both as reported according to GAAP standards and operating earnings, were negative.

This negative earnings report for the S&P 500 is a first. Year-over-year, S&P 500 earnings are down more than 67%. Dividends this year have been cut at a record rate of $16.6 billion. No wonder the market has been down by as much as 55% from the 2007 top.

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With free-flowing capital markets, it is hard to sustain meaningful price differentials between similar assets. The argument that short sellers are able to manipulate stock prices as they might have in 1938 is less powerful today. We now enjoy computer trading, which is capable of identifying and profiting from arbitrage opportunities in seconds.

If a company’s fundamentals are solid, it is almost impossible for the stock to remain significantly undervalued relative to like securities for any meaningful period of time.

Are ETFs to Blame for Market Meltdown?

Exchange-traded funds (ETFs) have been free from the uptick rule since their invention in 1989. One could argue that, given the liquidity and ease of trading ETFs, these financial instruments do more to cause uncontrolled market sell-offs than do the sale of individual securities. (For more on ETFs, see 10 Reasons to Use ETFs When Trading Options.)

Today, there are hundreds of ETFs, and the volume of ETF trading is exploding.

Let’s look at just one more closely: The 10-day average volume traded of the SPDR S&P Deposit Receipts ETF (SPY) is about 440 million shares, or about $31 billion per day. When it is time to panic, most fund managers simply short ETFs.

The real issue with short-sale stock manipulation is the regulation requiring that sellers obtain a “locate” before shorting stock. With the locate requirement enforced, eventually the short sellers run out of ammo, as there are only so many shares available for borrow.

Clearly the locate requirements were not being enforced during much of last year, as some stocks had far more than 100% of their outstanding shares sold short. Unlimited shorting without actually borrowing the stock is potentially a real source of stock price manipulation and is not allowed.

Although reinstating the uptick requirement may just be a feel-good measure, it could also signal that the pit boss is back on the casino floor.

Andrew Houghton and Nick Atkeson work together to identify options trading opportunities on the institutional level and, now, for OptionsZone.com readers. To learn more about them, read their bio here.

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