Have The Robots Broken The Stock Market?

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Includes: DIA, SCHM, SPY
by: Cullen Roche

As more and more economic data comes out, it is becoming clear that China really isn't having much of an impact on the US economy. Today's initial jobless claims is about as real-time as it gets, and they're near all-time lows. So now, Monday's flash crash is becoming an even hotter topic. Here's my experience, and why more human involvement might not be such a bad thing.

The markets were sloppy last week, and we went out on a bad note. Sentiment was very negative. And when Chinese stocks continued to crash on Sunday, it looked like we might be on the verge of something nasty. Uncertainty was everywhere. And then the robots took control. I watched the futures market almost all night on Sunday, and we were seeing 100-point moves in the Dow Futures contract within a few minutes. This was not human controlled. And it was not rational.

I reached out to a friend of mine who has some experience in High Frequency Trading, and here's what he said to me:

"I am beginning to wonder if certain algorithms don't get confused during these liquidity events. This week's trading looked like momo [momentum] algos chasing price which turned into a positive feedback loop on itself until the system just crashed."

That statement resonated with me. After all, I've traded through the rise of the robots, and I used to specialize specifically in illiquid markets, but I don't recall anything quite like this other than the Flash Crash of 2010. When I woke up on Monday morning and watched the market open, I'd never seen so many broken positions. There were dozens of ETFs trading at 25-50% discounts to their NAV. I was buying the Schwab U.S. Mid-Cap ETF (NYSEARCA:SCHM) at a 25% discount.

That is, I was playing market maker with my small asset management business in a broken market, because I looked at the prices and I knew for a fact, without seeing the Intraday Indicative Value of the ETF, that we were trading at irrational discounts. The robots failed to do that. Humans like myself, who have traded in these kinds of markets before, are like first responders. We run into the fire when everyone else is running away from it. Had there been more human market-making involvement that morning, I doubt this price discrepancy would have even occurred.

I am certainly not against the rise of the robots and the technological progress we're making, but some of the developments of the last few years do make me wonder if we're relying a bit too much on the robots at times...

Disclosure: My firm is net long SCHM (and has been for a long time) in many accounts.

P.S. - I should add that this does not add credence to some of the commentary that ETFs are illiquid or inefficient products. In fact, ETFs traded precisely how we should have expected them to. And when some underlying positions didn't open, many irrational sellers sold into the panic. This was not a product error. This was a human error. I wasn't the only one who recognized this error in real-time.