Anyone who follows the markets is aware of the "flash crash" that recently took the Dow Jones industrial averages down 1,000 points in one day. The regulators, experts and TV pundits have yet to explain or perhaps even understand what happened. We know a stock called Accenture traded from the $40 area down to 1 cent per share during the day and closed at nearly $40 again.
The problem arises from the recent phenomenon that brokers, professional traders and money managers are using computerized, high-frequency trading and algorithm trading. That means essentially that computers are programmed to scan the stock market for trading-price patterns that repeatedly result in near-term gains. And when those patterns appear, automatic orders are executed to buy or sell to catch the gains. Some of this trading is called "naked," meaning the orders go from the computers directly to the exchange floor without being handled by a brokerage.
A bad idea. The programs have been back-tested by scanning historical market records to verify that in the past the pattern virtually guaranteed a profitable trade. There is no analysis of the company's earnings, outlook, strength, dividend, or fundamentals of the industry or economy. There's only analysis of price patterns.
The problem laid bare in the "flash crash" was that new and unforeseen conditions arise, this time the sovereign debt crisis in Greece and the Eurozone. The computers acted as though they were scanning the same old patterns and executed accordingly. Then a snowball effect occurred as the computers read prices going down through support-action levels and executed additional cascading sell orders.
Inevitably, new market conditions arise, such as occurred in October 1987, when we had a devastating computer-driven and forced futures sales market meltdown. At that time, it was a scheme called "portfolio insurance." It only assured that huge losses occurred. Recently, high-frequency trading and algorithm-pattern trading, perhaps predictably, caused the "flash crash" as the computers blindly followed their sell order entry instructions down through various sell action signals.
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Until this computerized mania gets sorted out and is made transparent and regulated, we might expect to see increased market volatility and market declines accentuated and magnified. This will not enhance confidence nor encourage stock market participation by the average family, 401K holder or small investor.
Jim Waldo of Duluth is a retired broker of institutional research sales for Merrill Lynch.
