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What Happens When Investors Lack Trust?

Posted by Larry Doyle on August 6, 2010 1:05 PM |

Think the structure of the equity markets is broken? With the preponderance of equity volume now dominated by high frequency trading and true retail investors fleeing in droves, what do people think the chances are that we could experience another Flash Crash as we saw on May 6th?

Last evening, The Wall Street Journal ran an online poll on this topic in Legacy of the ‘Flash Crash.’ I have to admit, I was surprised by the results. Did you get concerned witnessing the 1000 point ‘whoosh’ in a very short time period on May 6th? An overwheming number of pollsters believe it can happen again.

With our computer-drive stock market, could a “flash crash’ happen again?

A close examination of the market’s rapid-fire unraveling on May 6 reveals some disturbing details about what unfolded. Three months later, many market veterans have arrived at a disquieting conclusion: A flash crash could happen again because today’s computer-driven stock market is much more fragile than many believed. Many investors, still gun-shy, have been pulling money out of stocks. What do you think? Are you hedging against another potential freefall?

As of late last evening, over 95% of participants polled believed that another ‘Flash Crash’ could happen. When risks are rising, investor returns need to rise as well.

Wall Street made this bed…now they need to sleep in it. The simple fact is the regulators and banks that developed the equity market structures failed miserably in protecting investors. People get this. They also get that nothing has truly changed or will truly change in the very near future. Those sentiments are expressed in the aformentioned polling results.

Gillian Tett addresses this same point in this morning’s Financial Times. She writes, Trading Volumes Retreat with Investor Trust:

…. in the equity world – which is perhaps the most visible cornerstone of American finance – retail investors are also on strike. Last week there were $1.5bn outflows from US equity mutual funds, after $3.2bn and $4.2bn of outflows in each of the previous two weeks. Indeed, in the past 12 weeks – or since May – there have been continuous outflows of more than $40bn.

So what on earth is going on? Optimists like to blame it on a summer lull, or temporary jitters about US unemployment or the eurozone. They may be right. But personally, I suspect that there is something more fundamental going on too.

…just to make matters worse, the memory of the May 6 “flash crash” haunts the markets. In the past three months, US regulators and bankers have scurried around trying to work out what caused equity prices to gyrate so wildly that day. But, thus far, they have not offered any convincing explanation.

That is shocking and profoundly debilitating. After all, it is bad for investors to feel confused about the outlook for government regulation or deflation; but it seems that nobody really understands how the basic mechanics of the equity market work any more, it is hard to trust that the stock markets are a good destination for your money.

The fact that investors have largely gone on strike and pulled out of the markets is a strong indication that they believe their capital is not being properly protected. These declines in volume are also occurring in the bond markets as well. While bonds very largely trade in the for profit over-the-counter markets, equities mostly trade on exchanges. These exchanges have become for-profit entities and investors have suffered in the process. Not that there were not issues on exchanges prior to their going to a for-proft model, but I would venture to say the issues paled in comparison to what exists currently.

Regulators should seriously think about reverting our equity exchanges to not-for-profit entities. Many in the industry would say that reversion would be impossible to achieve. I would respond unless and until investors believe their interests are truly protected, they will stay away.

LD

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  • fred

    LD,

    I could easily argue that the market has shown significantly more risk to the upside over the past few years. If their is no underlying support to the market, (sustainible economic recovery producing higher profit margins and earnings), the market should not trade higher, if it does it creates downside risk. This is nothing new.

    Historically, smart money buys early, holds to overvalued levels then sells to the dumb money, thereby banking a profit before the market corrects.

    The flash crash price levels were revisited and broken in short order thereby confirming the validity of the price. Should the market correct in one day what took 3 months to accumulate? Maybe not, but it happens from time to time.

    Is it really prudent risk managment to buy into an overvalued market using risk management tools to protect your downside. I would say no.

    I suspect smart money came in and and did some selective buying that day. If stops rather than options were used as a risk management tool you may have forced out of a good positions when indexes and etf’s pulled all stocks, both good and bad lower.

    Excesses are purged, back in 1987 it was options and options on futures that were being used to protect the downside in an overvalued market.

    I am very much against exchanges selling information (bid, ask, trade) for profit. As I understand it, for the right price, you can even tap directly into exchange computers, a must if your a high frequency trader. I suspect HFT were very active the day of the flash crash.

    • fred

      Markets have become more sophisticated. Not only must you practice risk management but you must diversify your technique, stops, options, vix, pairs trading, and going to cash.

      Today was a great example of purging the excess of risk management; alot of hedge and mutual funds have begun to hedge long portfolio beta risk using Vix (VXX); today, markets were down while Vix declined, the hedge didn’t work! Will this popular portfolio hedge provide the fodder for the next flash crash?

    • BMB

      On the contrary, I think many HFTs just shut down during the ‘flash crash’, which shoots a lot of holes in one of their supposed ‘reasons for being’, which is to provide ‘liquidity’. They are under absolutely no obligations to provide any sort of liquidity in times of market stress, and they will not. They just shut the machines down and walk away.

      Theirs is a type of ‘liquidity’ the markets do not need.

      • fred

        BMB,

        Being active and making a market aren’t the same thing.

        Being active can be as simple as entering a bid or ask then pulling it before a fill. Making a market has to do with providing liquidity by taking the other side of a trade.

        As far as I know an HFT practictioner isn’t necessarily a market maker or vice versa. The question that needs to be answered: Where were the market makers, they’re suppose to step up?

        When bids or offers are removed, it creates a liquidity vacume and prices can move quickly.

        • BMB

          Agreed. It’s just that the HFT folks continue to boast that they ‘provide liquidity’ to the markets when defending their practice, when in reality, they do no such thing. They merely trade for the sake of trading — many don’t even have to make money on the trades, since the exchanges pay them ‘rebates’ simply for making trades.

          You are correct that they are not market makers — but then they should not claim to provide liquidity as if they were.

          I also happen to believe that the act of “entering a bid or ask then pulling it before a fill” has been taken too far, when these machines are posting thousands upon thousands of orders that they have no intention of executing. There needs to be some point at which our markets are prevented from being some sort of ‘video game’ for these machines to play. Force bids/offers to be valid for a certain period of time — a second, maybe more. If there’s a chance that some of those orders may actually be filled, they may get a little more serious about real trading, rather than just trying to push prices around or fooling the bot next door.






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