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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.


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