TIME TO

RETHINK THE
FINANCIAL
MARKETPLACE
Talki ng P oi nts on
Program Trades,
Short Selling,
Buying on Margin,
Short-Term Holding,
Speculation,
Market Churn,
and Tax Policy
 Harry E. Emerson, III
hemerson @ SurferNETWORK.com
www.SurferNETWORK.com

TIME TO RETHINK THE FINANCIAL

MARKETPLACE

Talking Points on Program Trades, Short Selling, Buying on Margin,

Short-Term Holding, Speculation, Market Churn, and Tax Policy

We lost 2 trillion dollars of value in the last

week of September and first 10 days of October
2008. If that's ok with you, then you needn't
think about change. Otherwise, read on.

Accounting scandals. Lying and cheating CEO’s. The Internet boom and bust. The World
Trade Center September 11 catastrophe. The oil crisis. And now, “toxic mortgages” and
the financial industry melt-down. There’s much for the fingers of blame to point at to
explain the current disaster in the financial markets. But there’s much that isn’t being
discussed, especially in the context of recurrent financial industry disasters that affect
every American.

The purpose of this article is to raise issues and stimulate discussion on fundamental
matters of the ways that the financial markets function and how that affects the economy
and well-being of the nation. ECONOMIC DISASTERS ARE NOT UNAVOIDABLE --
they happen because our rules and regulations permit them to happen.

There are four elements of particular interest to this discussion: stock market controls
intended to minimize volatility; short selling; buying on margin; and government
policies, including tax policy, to discourage short term speculation.

IMPORTANT BACKGROUND
In entering this discussion, the first and most important thing to realize about buying
stock is that the company whose stock you are buying doesn’t get the money. You are
horse-trading with someone else who already owns the stock. Therefore, proposals that
might minimize volatility neither help nor hurt the company – they will, however, help
stabilize the market, which will help you, your retirement fund, and the nation as a whole.

A BRIEF HISTORY OF RECENT FINANCIAL DISASTERS

Remember Black Monday? The largest single stock-market drop in Wall Street history
occurred on "Black Monday" – October 19, 1987 –DJIA plunged 508 points, from 2246
to 1738, losing 22.6% of its total value. During the period of October 10th through
October 19th, the Dow fell by almost one third, representing a loss in value of all
outstanding United States stocks of approximately one trillion dollars. That one-day fall
far surpassed the one-day loss of 12.9% that began the great stock market crash of 1929
and foreshadowed the Great Depression. The Dow's 1987 fall also triggered panic selling
and similar drops in stock markets worldwide.
July 23, 2002 – updated Oct. 2008 Harry E. Emerson, III Page 2of 7
 Harry E. Emerson, III
hemerson @ SurferNETWORK.com
www.SurferNETWORK.com

Although many factors were cited as probable cause for this crash, the major focus
pointed blame on the use of computer trading (program trading) by large institutional
investing companies. In program trading, computers are programmed to automatically
order large stock trades when certain market trends prevail.

In response, the New York Stock Exchange (NYSE) restricted some forms of program
trading. The NYSE and the Chicago Mercantile Exchange also instituted a "circuit
breaker" mechanism by which trading would be halted on both exchanges for one hour if
the Dow Jones average fell more than 250 points in a day, and for two hours if it fell
more than 400 points. The concept is to provide a cool-off period, and then to resume
trading at a more regulated pace by instituting curbs against program trading. The NYSE
controls took effect on October 27, 1997 by halting trading for a total of 55 minutes while
the stock exchange suffered the third biggest loss in the preceding 111 years.

Since then the exchanges have been very forgiving to themselves, and have liberalized
these circuit breaker rules to the point where they are only likely to come into play in the
case of an unprecedented financial disaster. Put in context,

In the 2002 crises, the Dow Jones Industrial Average (DJIA) plummeted about 27% from
mid-May, until October 1st, wiping out 5 trillion dollars of shareholder value. This was 14
years after the controls had been put in place – obviously the controls are inadequate
from the standpoint of national well being.

PROGRAM TRADING "CIRCUIT BREAKERS" – RULE 80B

Circuit Breakers go into effect based on Dow Jones Industrial Average points. The point
values are set quarterly. The point values listed below are those in effect as of July 1,
2002.

If the Dow Jones Industrial Average falls 10% (1200 points), trading is halted on the New
York Stock Exchange for one hour if the decline occurs before 2 p.m.; for 30 minutes if
before 2:30 p.m.; and have no effect between 2:30 p.m. and 4 p.m.

If the Dow Jones Industrial Average falls 20% (2400 points), trading is halted on the New
York Stock Exchange for two hours if the decline occurs before 1 p.m.; for one hour if
before 2 p.m.; and for the remainder of the day if between 2 p.m. and 4 p.m.

If the Dow Jones Industrial Average falls 30% (3600 points), trading is halted on the New
York Stock Exchange for the day.

To put the circuit breaker rules into perspective, the companies traded on the NYSE
currently have a total market value of about $16 trillion. If the DJIA dropped 20% wiping
out $3.2 trillion of shareholder value, and if it happened between 1 p.m. and 2 p.m., the
brokers would take an hour coffee break before opening the throttles again. That’s not
much time for regaining composure – they need enough time to get a martini or two. But
you need to understand their motivation – the objective of stock brokers is not to
preserve the wealth of America, it is to buy and sell stocks, period. The more churn

July 23, 2002 – updated Oct. 2008 Harry E. Emerson, III Page 3of 7
 Harry E. Emerson, III
hemerson @ SurferNETWORK.com
www.SurferNETWORK.com

the better. A bad day for the market is a good day for Wall Street – they made
money, no matter how much you may have lost.

TRADING “CURBS” OR “COLLARS” – Rule 80A

For the third quarter 2002, curbs (or collars) kicked in if the DJIA was off by 180 points
from the previous day’s close – curbs would be released if the DJIA returned to within 90
points of the previous day’s close. When the NYSE institutes a program trading curb,
program selling can only be executed on an up-tick. That means that the last trade was
executed at a higher price than the trade before it. Program buying can only be executed
on a down-tick, meaning that the last trade was executed at a lower price than the trade
before it.

The intent of curbs is to prevent or moderate enormous volatility. Of course, as we all

know, there always are upticks. So forcing program trading onto an uptick is only a tiny
speed bump on the way to the cliff. To put perspective on the effectiveness of the present
curbs, according to the NYSE, program trading represented 33.4% of total volume in the
period July 8-12, 2002. Good for them, bad for you. It’s fair to wonder where your
portfolio might be if effective curbs had been in place. (As an alternative, consider the
impact if the rule were revised to require an uptick of ten or twenty points – program
trading would essentially be shut off. Or, consider the impact if curbs kicked in by a DJIA
drop of 20 points instead of 180 points from the previous day’s close.)

In establishing and adjusting both of these trading restrictions (circuit breakers and
collars), the brokers are policing themselves. And the last thing brokers want to do is
limit trading. The impact of the trading on you, on the marketplace as a whole, or on
the economy as a whole are not a direct concern. Brokers get rich on churn.

SHORT SELLING
The concept of the short sale is simple – “borrow” stocks you don’t own, sell them, buy
them back later at a lower price, and then return them to whomever you borrowed them
from. In the more blatant form called “naked short selling”, speculators simply sell the
stock, without borrowing them first. The reason traders sell short is that they expect a
stock’s price to drop.

The effect is that short selling forces a downward pressure on a stock; the vision
becomes the reality. It is self-fulfilling. Selling begets selling.

Consider the circumstance: You hold stock in IBM, along with millions of others. It’s a
true blue solid investment. But short sellers get a whiff of news that they think can be
parlayed into a downward movement. They don’t own IBM stock. Smelling blood, they
sell IBM short, by tens of millions of shares. Let’s say IBM was at $80. They start selling
in large volume for $78, $75, $72, and so on as the price drops. Many of the millions of
IBM shareholders get nervous at the precipitous slide. Some of them start to sell. The
price falls even faster. You look at your holdings – what did you pay when you bought in?
Is it time to get out? What is IBM’s long-term outlook? You question everything. Perhaps
you too, decide to sell rather than risk a washout. It becomes a rout – you lose, they win.

July 23, 2002 – updated Oct. 2008 Harry E. Emerson, III Page 4of 7
 Harry E. Emerson, III
hemerson @ SurferNETWORK.com
www.SurferNETWORK.com

“Short Interest” is the number of shares held short at any given time. It’s too early to get
the full data for the current crises, but we can look at 2002. For the NASDAQ market for
the month of June 2002, the 100 stocks with the largest “short interest” totaled over 2.2
billion shares being sold short. That represents enormous downward pressure on these
stocks, and on the market as a whole. Is it any surprise that NASDAQ stocks and the
technology sector in general have taken such a beating?

Among the NASDAQ stocks with the largest short interest were Cisco and Intel. For
June, Cisco had 75 million shares sold short, Intel had 65 million. Cisco dropped from a
high of $22 in December 2001 to $12 in July 2002, while Intel dropped from $37 to $17
over the same period.

Consider these numbers from the NYSE. For the month of June 2002, there were 2,961
issues with a total of 347 billion shares outstanding, and 31 billion shares were traded. As
of the short interest accounting period ending July 15th, the NYSE had 7.5 billion shares
sold short, representing 2.1% of the total outstanding shares in the entire marketplace,
and representing 24% of the total monthly trading volume. There’s no way that the
market can maintain its value when one fourth of the sales activity is by short sellers
driving down prices by selling stocks they don’t own.

The Uptick Rule: In June 2007 the SEC unanimously overturned the uptick rule, in
place since 1938, requiring that short sales can only be placed when the most recent sale
price of a stock is higher than the next most recent sale. In the current crises, short selling
is being blamed as a major cause of the worst financial disaster in this country’s history.
Despite that, the investment community by a large measure defends short selling and
believes the uptick rule should not be re-instituted.

The Counter-Arguments: Many in the investment community have been outspoken

regarding the SEC’s decision to temporarily ban short selling of 799 financial industry
stocks. The common thread is that short selling is important – it keeps stocks from being
over-valued and that thus improves market quality. They argue that we need shorts in the
market for balance so we don’t have bubbles such as the one that lead to the dot-com bust
of 2001. What these arguments ignore is that markets are inherently self-correcting, and
that it would be better to let the air out of the bubble gracefully, rather than sticking a pin
into it. The arguments in favor of short selling are those of self-interest from industry
insiders. The top officials of the SEC, the Treasury, and the Federal Reserve believe that
short selling is fundamentally importing to the marketplace. But remember, the SEC
voted unanimously to remove the uptick rule – they clearly have a biased view, and that
view is not in the best interests of the country.

Short selling destroys market value. It turns the value of the country into a casino, and
your IRA and 401(k) portfolios are the gaming tables. Certainly investors take risks. But,
it’s one thing for the owner of a stock to lose confidence and sell their position – it’s
something else entirely for someone who has not also risked that investment to destroy
the value of stocks owned by investors. There is no constitutional reason why someone
should be allowed to sell something they don’t own. If you want to sell a stock, buy it
first. Short selling should be outlawed.

July 23, 2002 – updated Oct. 2008 Harry E. Emerson, III Page 5of 7
 Harry E. Emerson, III
hemerson @ SurferNETWORK.com
www.SurferNETWORK.com

BUYING ON MARGIN
For stocks, the Federal Reserve Board’s Regulation T establishes a minimum margin on
new stock purchases of 50%. This means that you can purchase $100,000 of a stock with
a payment of $50,000. (The NYSE’s Rule 431 and the National Association of Securities
Dealers (NASD) Rule 2520 further define margin purchases.)

For commodities, such as oil, margin requirements are much more liberal. Traders on the
New York Mercantile Exchange can purchase a futures contract for 5% of the contract
price. Most traders are speculators, not commodity purchasers – they don’t really want to
purchase a tanker full of oil, they just want to bet on the price. While the commodities
industry vehemently denies that speculation has had anything to do with the radical rise
in oil prices, others think it is the singular cause.

Remember that these margin rules are established by the organizations which benefit
from larger numbers and higher values of transactions. Your financial security is not
their focus.

A test of reasonableness: Why should someone be permitted to purchase 1,000 shares if

they can only afford 500? Why should someone be permitted to purchase a contract
on a hundred thousand barrels of oil if they can only afford 5,000 barrels? The
answer is self-evident – they should not be permitted. However, the markets are designed
for speculation, not investment. We all pay the price when speculation gets out of hand.
Purchasing on margin should be eliminated.

SHORT-TERM HOLDING, MARKET CHURN, AND TAX POLICY

Let’s look at the impact of the existing tax policies. Have you perhaps noticed that there
are an enormous number of shares traded every day, compared to ten or twenty years ago.
Consider this. As of 2002, the NYSE had 347 billion shares outstanding, and about 31
billion were traded in a month in 45 million transactions, meaning that on average every
single share in existence is traded in a period of about 10 months or so. For the month of
June 2002, the annual turnover rate was 115%.

Now you know that Aunt Mildred hasn’t been day trading, and you’ve been watching
your 401(k) rot away before your eyes because you’ve been too afraid to sell. So how can
this much turnover exist when so many people just sit on their holdings? What it means is
that the institutions that do the most of the trading buy and sell the same stocks over and
over again, with every hint of bad news, good news, and no news. They don’t invest in
stocks; they gamble in stocks. They buy and sell a stock in less time than it takes you
to get lunch.

This means that the current tax policies do not encourage the primary trading institutions
to buy and hold stocks for their present and future value, nor do the current policies deter
these same institutions from speculative short-term trading. Many of these institutions,
pension plans and so on, may even be immune to influence by tax policies. For other
institutions, the hundred-thousand pages of tax code provide a labyrinth of loopholes that
will render any tax policy essentially ineffective.

July 23, 2002 – updated Oct. 2008 Harry E. Emerson, III Page 6of 7
 Harry E. Emerson, III
hemerson @ SurferNETWORK.com
www.SurferNETWORK.com

One way to discourage speculation with our national wealth would be to implement a fee
on stock transactions for stocks held for a short term -- less than a given period of
time. Let’s say the fee is 10% and the holding period is 6 months. Buying and then selling
a stock within the six month period will generate a fee of 10% of the purchase price of
the stock. It will not be a tax, it will be a fee, so it will apply regardless of the tax status
of the entity. And, it will not be able to be used to offset other taxes or obligations. The
net effect will be that holding a stock or other security for less than the holding period
costs money, encouraging investment and stability, and discouraging speculation with its
disastrous consequences.

CONCLUSION
We have allowed a key resource of the nation to be essentially unregulated and
uncontrolled. The institutions, brokers, day traders, and arbitrageurs thrive on volatility.
To them, volatility equates to new BMW’s. But to the hundreds of thousands of
employees laid off recently, volatility in the stock market means ruined lives and wiped
out pension plans.

It is time for this country to collectively determine that financial stability and growth are
more important than the financial success of the brokerage industry, and to establish rules
and policies for the financial markets that promote stability and growth. For example,
consider the impact if tax policies (and other, non-tax, policies) were put into place that
reduced stock transactions to, say, 10% of today’s levels – policies that promote buy and
hold (investment), not buy and sell (gambling). Markets, pension plans, funding
resources, and so on would be predictable, along with the general economy. It would
promote a great environment for long-term business growth and employment. But there
would be a lot fewer people working in the financial markets.

You’d want to short BMW.

July 23, 2002 – updated Oct. 2008 Harry E. Emerson, III Page 7of 7