Your editor’s phone began buzzing this morning shortly before 6am with texts asking us to turn on CNBC. There we saw what you saw: the Dow Jones had its largest-ever intra-day decline since 1987. The index fell nearly 1,000 points and almost ten percent as about $1 trillion in market value briefly got wiped out.
By the end of the day the loss was just under 347 points or 3.2%. And CNBC was reporting that the whole affair was trigged by a trader entering the wrong number on a trade, probably in Procter & Gamble stock, which fell nearly 37% at one point. CNBC said that, “The erroneous trade may have involved E-Mini contracts – stock market index futures contracts that trade on the Chicago Mercantile Exchange’s Globex trading platform. The composition of the E-Mini is similar to the stocks in the S&P 500.”
So maybe it was all just a misunderstanding. But it was a costly one. When computers take over decision making for human beings via program trading, then the catalyst for a given event can be erroneous and still have real world consequences. Program traders use algorithms that trade automatically buy and sell the market based on resistance and support levels determined by models.
Program trading accounted for about 24% of the trading volume every day for the most recent week for which data were kept, according to the NYSE. During the last week in April, that meant nearly 700 million shares a day were trading hands based on algorithms. It’s not hard to see what happened last night.
A featherless biped made a keystroke error on a P&G trade and erased $60 billion from the company’s market cap. The decline in P&G triggered automated sell orders which drove the Dow below 10,000. The very crossing of the Dow below 10,000 most likely triggered a flurry of buy orders. Voila! Chaos!
Well, not chaos. But certainly volatility. And you thought stock prices were determined buy buyers and sellers with live brains deciding the discounted current value of future earnings. Nope.
To us, the big takeaway from yesterday’s US episode is how, in the rush to digest and reprice news and information constantly, the market now appears susceptible to runaway feedback loops that swing prices and trigger buy and sell decisions automatically. This does not seem like an improvement in efficiency. It seems like a systemic vulnerability that could be exploited in the future deliberately to cause mass panic and wealth destruction.
Expect an investigation, although don’t expect anything to change…until next time.
The fact that traders freaked also shows you how uncertain investors now are. Just minutes before CNBC began going bananas over the fall in the Dow, Pimco’s Mohamed El-Erian wrote in a note to customers that the Greek crisis was leading to tighter inter-bank lending in Europe and “going global.”
Specifically, El-Erian said, “The transmission mechanisms for this latest round [of volatility] include disruptions in European inter-bank lines, a flight to quality, and market illiquidity…the Greek crisis tells you is debt and deficits matter… What you see is the system slowly starting to have cascading failures. It’s like a pipe that you need to be free-flowing and it starts to clog, and that’s a concern…This is a shock to the system and it’s going to have an impact on valuation.”
This resurrects the debate from 2008 over whether the GFC (which has morphed into a Sovereign Debt Crisis) is a liquidity crisis, a solvency crisis, a confidence crisis, all of the above, or none of the above. So which is it?
If the impending Greek debt-default isn’t contained, it WILL be a liquidity crisis soon enough. That’s partly what made New York traders so nervous after Europe’s session. In a leveraged world with falling asset values, liquidity issues become solvency issues. And none of that is good for confidence.
The only people we know that are loving this are traders and value investors. For the better part of three months Swarm and Slipstream Trader Murray Dawes has kept his powder dry. Today he’s firing new trades with both barrels. If you’re a punter, this is precisely the time to capture gains from mis-priced assets (those too cheap AND those too expensive).
It is frustrating for small cap and resource investors who are, if they’re being disciplined, getting stopped out of nearly all of the open positions recommended by Kris Sayce and Alex Cowie since the March lows of last years. Most, although not all, of these positions are getting sold at a profit. But it’s a lot of selling. What next?
The sliver lining to corrections and liquidations is that investors who’ve preserved their capital and cash can go shopping. What you want to buy is up to you. But prices (and generally valuations) are a lot more attractive after big falls. Both Alex and Kris may re-enter some of the same resource companies they’ve been forced to issue sell recommendations on this week. We’ll keep you posted.
As for our new project at the Australian Wealth Gameplan, it’s worked out well, although not for exactly the reasons we expected. Yesterday we recorded a 15-minute video analysing the effects of resource super profits tax and the Greek crisis on the Aussie market. China – whose real estate bubble we pegged as the big catalyst for the revaluation of Aussie stocks – was also discussed.
But no one saw a human trading error leading to complexity catastrophe of cascading sell orders on Wall Street happening this week. Not us anyway. But it did. And here we are, with a full-blown sovereign debt crisis in Europe, a manic market in America, and China’s falling stock market and metals prices indicating that its property bubble is deflating – slowly thus far.
That’s our story, anyway. And the plan-two specific investments designed to profit from the fall of the Aussie dollar and resource prices – is working out okay so far. The third thing going up now – volatility – is also tradeable, but a lot riskier. If you want to read more about the big picture gameplan, you can read the full “Exit the Dragon” report here. Until Monday…
for The Daily Reckoning Australia