Friday, May 21, 2010

Markets Run Amuck - Part II

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

Before I get into part II of Markets Run Amuck and discuss what I believe really happened on May 6, let me add some comments on what’s going on in the markets.

Generally speaking, I believe the weakness we are seeing right now, although being blamed on geopolitical events, is nothing more than normal and expected market digestion from the mini crash of May 6.

Historically, crashes and mini crashes are short-term events with an accelerant, something like pouring a torrent of gas on an already existing fire. It makes the fire much hotter, bigger, stronger and out of control. In market terms, crash-like behavior is volatility expanding to an extreme in a very short period of time. Stocks may have been seeing moves of +1% to -1% and all of a sudden that expands to +5% to -5%.

In the days and weeks (and sometimes months) following the crash or mini crash, volatility remains high, but steadily decreases, think of an ice cream cone that gets smaller and smaller the farther down you go. That’s what we are likely seeing right now. Volatility was at an extreme on May 6 during the mini crash and is still digesting that huge, outsized move. Often times, the low of the crash day is revisited at least once over the coming weeks and months, known as a retest.

So now, it’s ugly in the markets and lots of blood in the streets. While I don’t sense true panic, yet, there is certainly lots of worry and concern. If history is any indication, this correction should wrap in the next week or so and lead to another rally. Until proven otherwise, I continue to forecast the ultimate bull market peak this summer between Dow 11,500 and 13,000, something that seems as hard to believe now as it did last summer when I first mentioned it!

Getting back to the title of this piece, I want to spend some time talking about what I think really happened, who is to blame and what should be done. As I mentioned last week, I do NOT think this was the result of human error or a fat-finger mistake. The S&P 500 futures market and exchange traded fund (ETF) products was where the real crash began. It then spilled over and hit almost every stock as bids (buyers) totally evaporated and that giant sucking sound you heard was that of liquidity being drained.

Rather, the market was weak to begin with and buyers were not showing high conviction. Stocks were trading “heavy” and some large computer driven sell programs hit the market after 2:30 p.m. This triggered more computer driven selling and the specialists on the floor of the New York Stock Exchange (NYSE) saw something strange and decided, with good reason, to slow everything down. BUT, as they were trying to find order, the computers continued to pummel stocks that were also listed on the NASDAQ, forcing even more selling into a vacuum.

As an aside, this has been happening much more frequently since stocks went to decimalization, trading in pennies rather than 1/8, early last decade causing the NYSE specialists to reduce their risk appetite since reward was cut. Couple the increased involvement of computer driven trading and decimalization with the less price sensitive foreign market participant, and you’ve got a whole sea change of behavior in the financial markets.

Back to computers. Keep in mind, these are not your typical Dell or Apple computers. As I just learned at a conference on May 4, the most powerful computers can execute more than 1,000,000 trades in one second. Multiply that by the numbers of firms using them and the amount of capital at their disposal. It gets kind of scary! And when the specialists on the NYSE stepped away to try and slow the action down, mayhem broke out.

The reason you saw stocks trading at pennies or ridiculous amounts below their recent prices was because as bids dried up and the NYSE folks took a pause, computers searched for other bids to sell into, even if they were placeholder bids at a penny or a few dollars. In short, the system was totally broken for 20 minutes.

While it’s easy to blame all parties involved, and I watched the NYSE blame the NASDAQ and vice versa, I really think the computers got out of hand, just like they did in 1987, 1997, 1998 and 2008. Events the programmers assign a minute chance of occurring in 1000 years continue to happen with regularity. And computers are only as good as those programming them.

Since that day, Congress and the SEC have done a great job demanding explanation and assuring people that they will get to the bottom of the incident. To date, there has been little uncovered because it all happened in the norm of trading and there were no mistakes as far as I can see. Everyone is screaming for more circuit breakers to be added in order to stem the tide automatically when this happens again. I have mixed feelings when it comes to artificially manipulating the market. It makes sense from a populist point of view, but it has never been proven to do anything other than in the really short-term. Water finds its own level regardless of what you put in its way and all this does is put off the inevitable.

The problem I see is that you have a purely electronic market at the NASDAQ and a hybrid market at the NYSE. They are fiercely competitive and love to blame each other rather than work with each other. I would put them in a room with a mediator and not them leave until they agree on a compromise. My ignorant two cents is that when volatility really expands, I would rather have humans involved to try and keep a fair and orderly market moving than letting the computer run amuck. That may mean slowing down computer driven trading during extreme movements but not eliminating it. The tighter and tougher regulation there is, the more likely that business will move to a foreign market where conditions are more favorable. And that will cause liquidity, the prime source of market fuel, to disappear.

If you are interested, I will be interviewed on WTNH this Saturday, May 22, at 7:35am. Additionally, I will be on CNBC’s Squawk Box, today (May 21) at 9:40 a.m. as well as this Thursday, May 27 at 6:10 a.m.

Please feel free to email me with any questions or comments at Paul@investfortomorrow.com.

Until next time…

Paul Schatz

Heritage Capital LLC
http://www.InvestForTomorrow.com

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