The Securities Exchange Commission (SEC) voted 3-2 today for limits to be imposed on short-selling.  Under the new rules, short sales are prohibited (by a “circuit breaker”) when a stock falls by 10% or more.  The rule is imposed to prevent market turmoil.  According to Mary Schapiro, chairwoman of the SEC, “The reason this rule makes sense is because it recognizes that short-selling can potentially have both a beneficial and a harmful impact on the market.”  Her comment seems a little like a “yes and no”.  Let’s break it down.   Short-selling is beneficial as it allows for investors to bring overvalued stocks back to their “actual” value.  Short-selling is harmful when stocks are brought way below their “actual” value and investors trying to return the security to its “actual” value, by going long, are forced out of their positions.

The new rule may have some investors worried.  What if a stock really does decline by 10% in value in one day, I can’t profit from it?  Other investors may be upset as they understand the dynamics of a falling stock and now have had their “arbitrage” opportunity stripped away from them.  The politicians, however, are likely happy at the SEC’s divided decision.  The shocks and fear felt by a quickly declining stock (especially one with heavy influence [think Enron]) will not take hold as long as this rule is in place.

Investors got some comfort at least as Bernanke testified before Congress saying interest rates would remain low.  Financial stocks shot up on Bernanke’s words.