In Focus

August 20, 2007

he markets are volatile, no doubt. Much of the blame goes to problems that started in the sub prime space and spread. But sub prime does not deserve all of the blame. Effective July 5, 2007 the SEC did away with their up tick rule for short sales. Now a trader does not have to wait for a stock to trade up before selling short. As you can imagine this significantly lowers the cost of shorting shares. Our Pricing Theory courses tell us that a lower price leads to greater demand. The problem is the reasons for shorting have stayed the same. Therefore certain shares are being shorted that otherwise would not, and/or shares that should be shorted are being traded down the prices that are too low. This activity attracts buying. The buying leads to short covering or panic buying. Thus we see days that are down 200, up 200, down 200 up 225 and finishing the day pretty much were it should have...Up just a little given the current good economy with near double digit corporate profit growth, low unemployment level and rising wages. Plus we saw today that export prices were up, which is another good sign for the consumer who accounts for 2/3s of our economy.

The volatility today goes beyond sub prime. The increase is the result of the up tick rule being dropped. This rule had been around since 1938 and worked well. I have no idea what the justification was but it was dropped nonetheless. The problem is this spells troubles for quant model funds. These are the kind of funds that rely on computer-based decisions to make trades. There are many. All use market volatility as a critical input. My feeling is most use volatility numbers that are too low because they are based on a history when then up tick rule was in place. When their model volatility adjustment is made to consider the market is riskier, these funds will sell stocks and buy bonds. This will create additional, temporary negative volatility for the stock market. In other words, there is one more shoe to drop before the correction is complete.

Note that in the month prior to July 5, 2007, the VIX traded mostly between 13 and 15. There was an exception based on sub prime/Bear Stearns concerns. Between 2004 and June 30 2007 the VIX traded between 10 and 15. Since the elimination of the up tick rule, the VIX has traded between 15 and 28. Volatility is here to stay!

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David P. Brady, CFA is the founder of Brady Investment Counsel LLC, an investment management service based in Geneva, Illinois. He can be reached at 630.845.1125, or visit Brady Investment Counsel LLC on the web at www.bradyinvestmentcounsel.com.