How the SEC Can Help Lessen Market Volatility

Dr. Edward Yardeni is president and chief investment strategist for Yardeni Research Inc.

KIPLINGER'S: Explain the uptick rule, please.

YARDENI: It was a rule created by the Securities and Exchange Commission that required traders to wait to short a stock until its price went up. [Short sales involve selling borrowed shares to bet that the price will drop, then replacing those shares at a lower price.] The rule was established in the 1930s and was designed to stop traders from ganging up on individual stocks and driving prices down in a free-fall market. The rule was repealed in 2007 after studies showed that markets would not be hurt by its absence.

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What impact has the repeal had on the market? I think its repeal has contributed to the major volatility in the markets. There's some controversy about the rule, but if we brought it back I think it would help restore liquidity and lower volatility. For one thing, bringing back the uptick rule is one of the best ways to reduce high-frequency trading [in which computer-driven trades are executed in nanoseconds], which I think is contributing to volatility and impeding a sustainable rise in stock values. Most of all, bringing back the uptick rule would help restore individual investors' confidence in the market, which has been lost in the wake of the volatility.

How much of the volatility is due to high-frequency trading versus uncertainty surrounding the European debt crisis and the U.S. economy? That's a good point. Curtailing or banning high-frequency trading doesn't mean we'll never have bear markets again. It means that markets will likely be less volatile and will be based on fundamentals rather than on computer algorithms whipping people in and out of shares.

What are the odds that the SEC will reinstate the uptick rule? Not good. The SEC study suggested that the uptick rule was never effective in the first place. However, as with every academic study, a lot of assumptions went into its preparation. And some of them, I think, are questionable.

Are there other fixes besides the uptick rule? There has to be a complete reassessment of the deregulation that has occurred. Deregulation should increase liquidity, transparency and fairness of markets, and there should be a tremendous amount of scrutiny to ensure that no one games the system.