PREVENTING STOCK MARKET CRASHES

After every stock market crash we search for the causes and change rules and regulations to prevent future recurrences. Politicians are not well suited for the task. It is unlikely that the current rules and regulations will prevent a future crash because they fail to prevent or adequately limit use of practices which exacerbate market declines such as short selling, stop loss orders, chart theory and excessive margin buying which leads to margin liquidations in declining markets. Managers of many large pools of capital understand the effects of such practices and execute trades timed to further enhance extreme market declines so that they can then become buyers after the precipitous decline.

The talking heads on financial news networks have speculated lately on whether a 20% stock market decline like the one that occurred on October 19,1989 might occur again. They discuss the fact that a 600 point decline in the Dow is currently only about a 2% decline and that a 20% decline would amount to more than 5000 points in the Dow. They often talk about the differences in the US economy between 1989 and now, the possibility of a recession, the strength of corporate earnings and balance sheets, the trade war with China, tariffs, the effects of negative European interest rates, the rate of inflation and the Feds current stance on interest rates and its balance sheet. However, I haven’t heard them talk recently of governmental regulations or controls in place to prevent the recurrence of a 1989 type decline. The safety net value of current regulations and controls in place were about to be tested last year until the Fed reversed its course on interest rates after raising interest rates too fast and projecting ridiculously stupid further interest rate increases and balance sheet reductions. Has the Fed already forgotten the result of its successful policies which enabled our economy to escape from the Great Recession. Does the Fed understand that excessive stock market declines can lead not only to a recession, but as in the 1930’s to a depression? Fed chief Powell stupidly talks of patience when he should have admitted his error in adopting overly restrictive Fed policy decisions. 

Most of us learned from old western movies that a rancher who wishes to avoid a stampede of his horses or cattle builds secure fences or takes precautionary measures when moving his herd. Our current securities regulations and controls which are designed to stem an out of control decline were influenced by investment bankers seeking to maximize their profits by encouraging speculative practices in disregard of stock market stability. Brokers profit from charging high rates of margin interest and charging short sellers for borrowed stock. Speculators often profit in declining markets from short sales at declining prices made possible by the elimination of the uptick rule. A combination of factors acting in concert, including short selling at declining prices,  stop-loss order liquidations, margin calls, tax selling, reaching chart theory sell points and panic, cause stock price declines to be exaggerated.

Now is the time to take action to change the government regulations and controls of the securities markets to greatly reduce the probability of a crash. The Fed and the SEC should work together. Here is what I propose:

  1. The SEC should immediately reinstate the uptick rule and prevent way to avoid it. It was lunacy to remove it.
  2. The SEC should ban all new short selling when  any of the Dow, S&P or the NASDAQ averages (the “leading market averages”) have declined more that 20% from their 6 month highs; and continue the ban until all such averages have recovered at least 10% from their low point after the ban is put in place.
  3. The Fed should limit the risk of margin liquidations by changing margin requirements to provide that aggregate initial margin in an account shall be reduced to 40% during each 30 day period after which any of the leading market averages has hit a 12 month high.
  4. The SEC should change the way stop loss orders operate. Make them become good until canceled limit orders and not market orders when the stop loss point is reached. This will reduce the avalanche aspects of sales at declining market prices and discourage misplaced reliance on the protection of stop loss orders.
  5. Try to reduce dumping of large numbers of shares by active traders by charging a small fee on the dollar amount of all sales of securities held less than 5 years.

The Feds goal of full employment is negatively impacted by stock market declines. A reduction in the wealth of investors negatively impacts their spending. The Fed should stop talking foolishly about “patience” and clarify that it intends to reduce interest rates and engage in QE whenever stock prices decline significantly.

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