May 7, 2010

Market autopsy

There aren't many convincing answers available at this point regarding what actually caused yesterday's mini-panic, but one thing is clear regarding yesterday's crazy day: there was some serious weird stuff going on. Here's a brief recap.

First, here are the lowlights of how it unfolded:

2:00 p.m., Dow was down 155 points
2:40 p.m., down 415 points
2:47 p.m., down 988 points
2:57 p.m., down 388 points
4:00 p.m., down 347 points

So what happened? Investigators are poring over the details today, I'm sure. Among the oddities uncovered so far, the Wall Street Journal reports:

Multiple stocks, ranging from Accenture PLC to Boston Beer Co., momentarily lost nearly 100% of their value, changing hands for just one penny. Exchange-traded funds, which are index funds that trade like stocks on exchanges, were also temporarily vaporized. The $9.5 billion iShares Russell 1000 Value Index Fund went from $59 to around 8 cents in the blink of an eye.

At least six stocks went to zero, and at least one (Sotheby's) went from around $30 to $100,000 momentarily. Some traders report seeing others experience this kind of crazy behavior.

Most of what I'm reading this morning indicates that an errant trade — I've seen a couple reports that one Proctor & Gamble trade was entered with a billion rather than the intended million — sent the computer algorithms into a spasm.

Computer trading is the only one way I can imagine how a giant ETF trading at $59 gets executed at 8 cents a share moments later. Automated algorithms account for a huge percentage of the daily volume in the markets, and that's not all bad — it's one of the forces responsible for typically narrowing the bid/ask spread to a single penny in recent years (many of you likely remember the old fractional system when 1/8 — 12.5 cents — was the narrowest spread available).

The only problem is computers don't have "common sense" to recognize something is totally out of whack in conditions like that seven-minute window yesterday. They just keep following their rules and driving things further and further out of whack.

Expect some serious questions to be asked about these systems and how to better protect the whole market system in the future. In a way, given that things didn't melt down into total chaos yesterday, it may have been a helpful wake up call that can strengthen the system for the future.

And frankly, as scary as it is to realize the system has flaws like these, it's comforting in a way that the cause of the meltdown was likely mechanical rather than a genuine fear-based selling panic. Mechanical flaws can be addressed more easily than market psychology.