Be careful what you ask for!!!

Most everyone except those hiding under a rock for the past couple of days are aware that world markets have been roiled by the news of the bankruptcy of Lehman Bros., the sale of Merrill Lynch to Bank of America and insurance giant AIG’s need for a large infusion of capital. To be sure, there are many questions and many factors today that did not exist in years past. Take investors, for example. Today, we have individual investors, registered investment advisors, large brokerage firms, traditional hedge funds, 130/30 strategies and pension funds investing significant portions of their portfolios in commodities, to name a few. This diverse group of investors has added to the volatility that we are seeing today in the bourses around the world. In fact, in the past 6 months, we have seen more daily swings of 1% or more in the US stock market than we have in the previous six years. In our opinion, the uptick rule or, more appropriately, the lack thereof, has contributed greatly to the detrimental results of the past few months.

It was a little more than a year ago that Wall Street firms were petitioning the Securities and Exchange Commission (SEC) to nullify a rule established in 1934 to help prevent what are known as “bear raids” on financial companies. This rule was called the “up-tick” rule. This rule prevented short selling from exacerbating losses in stocks by not allowing a stock to be sold short (betting the price will go down) when a stock is going down. You could only short a stock when there is an “up-tick” in the price of the stock. For example, assume a stock has only 5 trades in a volatile market. The first trade is $28 a share, 2nd trade is $27 a share, 3rd trade is $26 a share, the fourth trade is $25 a share, and the 5th trade is $25.10 a share. Under the old uptick rule, you could not short this stock until the 5th trade when the share price “up-ticked” 10 cents to $25.10 a share. In other words, you could not compound the decrease in the stock price by selling it short. Starting in July of last year, the up-tick rule was abolished. Firms like Merrill Lynch, Bear Stearns and Lehman Brothers wanted the SEC to abolish the rule because they had developed a “new” investment gimmick called the 130/30 strategy. Basically, these firms take a portfolio and go 130% long/ 30% short. In order for this strategy to be successful, they needed the up-tick rule to be abolished so they could short stocks more readily. However, these firms never expected the abolition of the rule to turn on them when their own stock was sold short and pressure on their stock price made it impossible for them to raise capital. This is a classic example of a “bear raid.” Bear raids were prevalent before 1934 and the up-tick rule was established to prevent them from occurring, especially with financial firms because financial firms are so highly leveraged. You will likely never see a bear raid on stable firms with great cash flow, such as P&G.

The following link is to an article on the collapse of Bear Stearns from Vanity Fair that shows how a bear raid works (who would have guessed that they have the best piece to explain what happened!): http://www.vanityfair.com/politics/features/2008/08/bear_stearns200808

If you have the time to read the above article, you will quickly determine that one of the keys to a bear raid is the combination of selling a stock short and spreading rumors. The demise of IndyMac is a perfect example. Ten days prior to IndyMac’s ultimate decline, an influential Senator who will go unnamed, wrote a letter questioning their solvency. During the following ten days, over $1.3 billion in deposits were withdrawn. It was a classic “run on the bank.” We believe strongly that the SEC needs to reinstate the up-tick rule and take these rumor mongrels out of the market. Such action by the SEC would be a big step towards re-establishing an orderly stock market and limiting the bears ability to pummel a stock to the point of extinction, as we have seen in the case of Lehman Bros., IndyMac and Bear Stearns, especially if the losses are picked up by the taxpayer!

Recently, Alan Greenspan stated that the actions of the past couple of days are the largest event in financial markets in 100 years. The event of 100 years ago Mr. Greenspan was referring to was the “Panic of 1907”, the last major bank panic. To learn more about this bank run and how the stock market reacted to the news, we would recommend reading the “Panic of 1907” written by Robert F. Bruner and Sean D. Carr. The book details the last major bank panic – similar to what is happening today. One of the key takeaways from the book, in our opinion, is that we survived the fear and panic that set in and the stock market rebounded nicely over the following 12 months. We have attached a chart from the book illustrating this point.

So, although we do not have any specific answers to when the stock market will establish a bottom and begin to move forward, we do believe that there is a light at the end of the tunnel which we can now see. As always, we urge you to call us whenever you have concerns about your portfolio and we hope your week is a good one.