The Financial Equivalent of Bungee Jumping

One quick note on my book reviews. I have two books read, and ready to review. I am reading Harry Markopolos’ book on Madoff, and am almost done. That book really needed a stronger editor. Next in the queue after that is Tony Boeckh’s new book, The Great Reflation.

I had other things planned to write this evening, but the brief plunge in the equity markets this afternoon caught my attention. What caused the mini-panic? Was it:

  • Dynamic hedging, a la 1987?
  • A “fat finger” placing a sell trade that was too large?
  • Panic of a single trader? Or, maybe a few?
  • Or, program trading gone awry?
  • Or, some combination thereof?

    The “fat finger” hypothesis seems to be ruled out. The NYSE says that there were no erroneous trades on their exchange, though they blame NASDAQ, and the NASDAQ is canceling trades where the rise or fall was over 60%.

    My guess is that electronic trading got out of control, because human beings would not offer to sell the stock of valuable companies for exceptionally low prices, in some case less than a buck or less than a penny.

    Yes, there might have been some dynamic hedging. And some traders likely panicked and sold when they should not have. But, buyers came in and prevented the market from tripping circuit breakers that would have shut down the markets for half an hour. We came with a few points on the Dow of doing that. No telling what might have happened if that had occurred. There might have been a greater panic, or, a greater resurgence in the last half hour. Curious that we got so close to that uncertain trigger, but did not cross the line. More grist for the mills of conspiracy theorists. All I can say is that I snagged some shares of Noble Corp @ $35.40, near the low of the day.

    I said to one of my sons — there are four ways to act on a day like today:

    • The brave man: “Buy, buy, BUY!!!”
    • The wise man: “I will buy a little more of this undervalued stock.”
    • The indexer, or buy-and-holder: “Huh?”
    • The wimp: “Get me out of these stocks, they are killing me!”

    We do not know what tomorrow will bring. I had a very good relative value day, while losing quite a bit in absolute terms.

    But my sense of the day is that some algorithmic trading programs went wild, and made trades that no sane human would. John Henry may yet prevail in the markets.

    But one note before I close: NASDAQ should not have canceled the trades. It ruins the incentives of market actors during a panic. Set your programs so that they don’t so stupid things. Don’t give them the idea that if they do something really stupid, there will be a do-over. In the absence of fraud, trades should not be canceled.

    Full disclosure: long NE

    About David Merkel 144 Articles

    Affiliation: Finacorp Securities

    David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

    In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

    Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

    I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

    Visit: The Aleph Blog

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