Who…..or What is to Blame For the Recent Market Volatility?

February 6, 2018 12:30 pm

Derek M. Amey

Partner & Portfolio Manager

The Supreme Court back in 1919 found that while the freedom of speech is protected under the First Amendment, it does not however protect “dangerous speech.” The definition of dangerous speech being purposely vague. An example was provided by Supreme Court Justice Oliver Wendell Holmes in which he said “falsely shouting fire in a theater and causing a panic” would not be covered. The ruling has since been retried and the findings updated to say essentially, that just causing a dangerous situation isn’t enough, that it must encourage other to act in a certain specific way on their own.

Now imagine if the person isn’t a person after all?

What if the person was a machine?

And what if the theater was actually the stock market?

And instead of spooking other people, it was other machines they caused to panic?

Stocks have been moving wildly in both directions the past few days, and there’s a growing sense that computers are the cause. In a 15 minute span on February 5th, stocks fell over 800 points, and then rebounded 800 points. This is not normal behavior and certainly not something typically explained by the actions of a group of traders. The most likely culprit is algorithmic computer-based trading systems that knowingly or unknowingly all decided to move in unison. The catalyst will never be known; in fact, to this day no one knows why the market peaked in 2007, and why it just stopped going up. But one thing is for sure: someone or something yelled “FIRE” yesterday and the machines responded.

 

Gone are the days of trading being dominated by men and women on the floor of the stock exchange. In fact, gone are the days of “exchanges” as we know it. The NYSE, for all its history has become more of a museum to the past than a fully operating exchange. As far back as 2007, they started realizing that due the rise of computer trading, they didn’t need as much space for a trading floor. Computers eliminated the need for face-to-face trades, and in response the NYSE started to shrink the operation. (http://www.nytimes.com/2007/09/23/nyregion/23exchange.html)

Make no mistake, the computers are built by humans, and the trading algorithms that are used to make trading decisions have been programmed by humans. But computers don’t take lunches, and they can trade faster than any human being. For all the benefits technology and computing power represents, its impact on the stock market, both good and bad, is still very much in debate. Personally, as much as the past few days have been a difficult time, I believe that every investor has benefitted from the increased use of technology.

This isn’t the first time we’ve seen the impact that machines can have on markets, especially in times of heightened market turmoil. Back in 2010, the major indices experienced a flash crash during a particularly bad day when markets were spooked about the potential default of Greek debt. In the span of 10 minutes, some individual blue chip stocks saw their prices drop by as much as 25%. (https://en.wikipedia.org/wiki/2010_Flash_Crash) There’s been a lot of regulatory review of the “how” and “why” that Flash Crash occurred, with a lot of finger pointing at the rise of machine-based trading. However, the biggest issue still exists: if you can’t get everyone to agree on the catalyst of such irrational market behavior, it’s impossible to get everyone to agree on how to fix it.

Fast forward to this week. Around 3pm on February 5th, the Dow Jones Industrial Average was down 700 points, when it suddenly sank another 900 points. Regardless of how fast someone can type or yell into a phone “sell, sell, sell’ they couldn’t do that kind of damage to the entire stock market. It appears that for some reason one of the machines yelled “FIRE!” and spooked the rest of the computer-based programs into massive selling. (https://www.bloomberg.com/news/articles/2018-02-05/machines-had-their-fingerprints-all-over-a-dow-rout-for-the-ages).

Program trading, or algorithm trading, works both ways. Stocks can and have rallied just as quickly as they fall, when the machines all agree to move the market in unison. This is not to insinuate some sort of collusion. The more realistic explanation is that a lot of these computer programs are being written on the backs of the same assumptions. At its most simplistic level, imagine hedge fund firm “A” goes in and writes a computer code that says to sell their stocks if the DJIA falls more than 5% in one day. Unbeknownst to them, hedge fund firm “B” has written an extremely similar code. When that trigger suddenly happens, there’s no thought behind the rationality of it. The computers do what they’ve been programed to do.

Will we see more trading days like this in our future? Absolutely. The industry needs more regulation and more analysis on the impact all this computing power has on the minute-to-minute moves of the market. The current working thesis is that every so often the stars align and the programmed computers’ sell signals align and the market goes haywire. One would hope that’s the real answer, and not that there’s a far more nefarious reason, because if it was more nefarious:

What’s the punishment for when a machine yells fire in a crowded stock market?

 

 

 

Derek Amey serves as Managing Director and Portfolio Manager at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail him at damey@strategicpoint.com.

The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Derek’s opinions and comments expressed on this site are his own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.