The May 6, 2010, market crash has been characterized by some as a Black Swan Event (Nicholas Taleb coined this term in 2007 to define a market event that is rare, has extreme impact, and retrospectively - though not prospectively - predictable). While some are viewing the events of last week as a Black Swan, we believe that the markets are prone to more rapid drops like this in the future.
On May 6, 2010, the Dow Jones Industrial Average (“DJIA”) dropped 1,080.95 points (9.9%) from its May 5, 2010, close of 10,868.12 to a low of 9,787.17 – then rebounded 733.05 points (7.5%) to close down 347.80 (3.2%) at 10,520.32. The Wall Street Journal called the sudden plunge from about 2:48 p.m. to 3:00 p.m. a “high-speed drop.”
In this short time: Apple, Inc. (NASDAQ:AAPL) dropped 23% from $258 to $199 and then rebounded to $246; Accenture plc (NYSE:ACN) dropped 100% from $42 to $0.01 (trading was cancelled and the day’s low was changed to $17) and then rebounded to $41; and Proctor & Gamble (NYSE:PG) dropped 37% from $63 to $39 and closed at $61. Many investors with stop loss orders got taken to the cleaners as the market ran through typical 10%-20% stops and then rebounded to prices far above this type of safety net. In essence, the market’s erratic behavior “tricked” investors into selling stock that they should have held onto.
Pundits attribute the sell-off to a variety of things, including a Black Swan Event, turmoil in Greece, decline of the euro, overpriced equity markets, illiquidity, market psychology, the now famous “fat-finger” trader that entered a sell order for 16 billion shares of PG rather than 16 million shares, high-frequency traders, and no uptick rule. It almost doesn’t matter what the pundits say, the plain fact is that the selling panic ended the day with stocks down, the dollar up, the euro down, and gold up.
While economic causes contributed fuel to the fire, our view is that the markets are becoming increasingly fragile with the rise of large pools of capital engaged in momentum-based, high-frequency trading programs. Algorithmic traders, without any duty to supply liquidity to the market when it is needed, are now estimated to have a 70% share of the daily trading volume on the NYSE. To this powerful force, add the fact that the SEC eliminated the uptick rule in 2007, and the algorithmic traders had a clear field to sell short, drive prices down, buy at the bottom, drive prices up, and make a fortune while taking investors to the cleaners. (The SEC eliminated the uptick rule in 2007 and approved an alternative uptick rule in 2010 (Rule 201), but it is not yet effective and not likely to have much impact.)
Black Monday refers to Monday, October 19, 1987, when global stock markets crashed. The DJIA dropped 508 points to 1,738.74 (22.61%). The Black Monday decline was the largest one-day percentage decline in stock market history. The possible causes for the decline include a Black Swan Event, overvaluation, illiquidity, market psychology, currency fluctuations, and selling by program traders. The possible causes are the same ones we hear today. Black Monday has been studied by the SEC, government, academics, and others; yet its cause remains a mystery.A Black Swan Event is not forecastable, but this crash was imminently forecastable. The impact on the market of large pools of capital engaged in momentum-based, high-frequency trading programs, without any obligation to provide liquidity, makes the odds of a “high-speed drop” very high. The markets have turned into Casinos and investors should expect more steep and rapid market declines until the house changes the rules of the game.
Element Alpha (www.element-alpha.com) is a securities research firm that allows the individual investor to manage money and outperform benchmark indexes by investing in stocks within those targeted indexes. This is made possible by a proprietary algorithm that was developed over the last decade and validated by third-party mathematicians.
Disclosure: No positions