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David's Macro Blog

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Tag: Flash Crash

It is always interesting to go back and read what I wrote last year because often I’ve forgotten! Plus it is humbling to realize how imperfectly we see the future, which looked so clear at the time.

My favorite quote for 2010 is:

“Prediction is very hard, especially about the future.” – Yogi Berra

Let’s take a look at the past year and what happened. My next post will contain my 2011 predictions.

Notable Events During 2010

Economic

  • The unemployment rate is just below 10%, which is about where it was at the end of 2009. Most of the decrease came from a decline in the Labor Force Participation Rate and Employment Population Ratio. Some new jobs were created but far below the number needed to decrease unemployment down to a reasonable 6% range.
  • Consumer spending recovered remarkably well despite no real improvement in unemployment.
  • Credit was tight for those at the lower ends of the financial spectrum but was certainly extremely loose for large financial institutions and businesses.
  • The stock market continued its climb back up from the 2008 Financial Crisis lows, yet suffered the May-6 Flash Crash. There was plenty of volatility in the trading ranges.
  • The S&P 500 rose about 12% to 1257.
  • Commodity and precious metal prices rose during the year. Gold and silver are at new highs and oil is back to $90 per barrel.

Real Estate

  • Real estate prices continued to stabilize across most markets.
    • The residential market is of course driven by location. Most lower priced homes already fell dramatically because subprime loans were the first to fail. Now higher priced homes are showing weakness.
    • In the commercial market, there was a bifurcation of assets. The best assets actually saw increased prices and rents because investors were chasing yields higher than bonds. The lower-end assets fell because they don’t produce much stabilized income.
  • U.S. home mortgage rates fell to multi-generational lows in the mid-4% range. This wasn’t expected originally because it was projected to rise when the Fed ceased buying additional mortgage debt.

Political

  • Reappointment of Ben Bernanke as Fed chairman in closest vote ever.
  • The Federal government still has a $1 trillion budget deficit. We’ll see if the new, more conservative Congress reins in spending (not too likely). At some point the Federal debt problem will have to be addressed as in Greece.
  • States, counties, and cities did not go bankrupt en-mass yet. However some politicians are speaking out on their budget crisis finally. We may see radical change in 2011.
  • The Federal government passed sweeping national health care reform. The effects are just starting to be known.
  • The Federal government also passed financial reform legislation. The effects aren’t clear yet, but does anyone think radical reform will improve abusive behavior?
  • The power of the financial industry over the American economy and the government became more evident.
  • The Fed kept the money flowing with Quantitative Easing 2 (QE2). When QE2 ends, will QE3 be required?
  • Economies in Europe and even the Euro currency experienced major challenges. There were bailouts in Greece and Ireland, with more on the way for Portugal, Spain, and maybe Italy. Curiously Iceland opted out of the bailout scheme and is recovering faster than expected.

Now let’s review some of my 2010 predictions and grade them.

Most Accurate Predictions from Last Year (2010)

Perhaps unemployment might fall below 10%, but it should remain at or near double digit territory.

Pretty accurate, unemployment for December 2010 came in at 9.7%.

[Interest rates] are at zero and should remain there for 2010. Remember, Japan had zero interest rates for 10+ years. It can happen.

There wasn’t any hint that short term rates would move up from the 0% -0.25% range they’ve been in for awhile now. Honestly this wasn’t difficult to predict so it hardly qualifies as a “most accurate prediction.”

If forced to make a firm prediction, I’d say the best chance of a currency crisis is in the EU, not Asia or North America.

The European Union did have a very large currency crisis in the form of bailouts. The EFSF was formed to backstop unmanagable debt in countries like Ireland, Greece, and eventually Spain and Portugal.

Least Accurate Predictions from Last Year (2010)

The market indices should fall in 2010 and stay within their prior 2 year trading range with a 1/3 chance of retesting the prior lows of March 2009.

The stock market finished up about 12% (S&P 500). There were some swing trades up and down but in general the stock market continued its recovery.

If the economy doesn’t suffer a major meltdown and doesn’t recover either, then gold prices will probably flatten and possible show downward bias.

Gold (and silver) prices didn’t fall in 2010 – they increased instead as investors and hot money flowed into alternatives to risky paper money.

Oil prices remained in the $60 to $80 range for most of the year [2009]. I expect more of the same and a downward bias too.

Oil prices finished year 2010 at $90/barrel as the global economy strengthened and GDP grew. I expected slower growth, which would have likely kept oil prices lower.

Jon Stewart, one of the most astute and insightful commentators of our time, explains the May 6th 2010 Flash Crash in this video from the Daily Show: A Nightmare on Wall Street

The Daily Show With Jon Stewart Mon – Thurs 11p / 10c
A Nightmare on Wall Street
www.thedailyshow.com
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If you are a day, swing, or momentum trader, how would you trade in this market? Did trading on May 6th blow through all the sell stops on the order books?

Well, I have one friend who is an accomplished trader and he related his strategy regarding this issue. He refrains from trading if the market moves too violently or if there isn’t a clear reason for the market movement (e.g. a war, terrorist attack, major corporate bankruptcy, etc.)

One supposed benefit of an electronic marketplace and program trading by black box algorithms (algos) is market liquidity that would prevent just this type of collapse. The October 19th 1987 Black Monday crash was supposedly caused by computer program trading. It happened again this time — did we learn anything?

Or, as the saying goes:

History is the same events happening to new people who experience it for the first time as though it never happened before.

On Thursday May 6th the stock market took a unexplained and terrifying plunge down 10% during the day.

This highly unusual event called the “Flash Crash” can be seen in real time on CNBC as Erin Burnett is interviewing Jim Cramer on Street Signs.

There are many (some conspiracy) theories as to the cause of the “flash crash,” which call into question the robustness of our nation’s financial systems.

How robust and sound is our financial system when the stock market can fall 10% intraday or about one trillion dollars?

Here are a few of the reported potential causes and conspiracy theories that may have triggered the crash.

  • A trader made a “fat finger” error and pushed the wrong key on his keyboard selling a unusually large amount of contracts which exceeded the supply available. This is essentially a typo error.
  • There was a large legitimate sell order on the S&P e-mini futures contracts which caused all markets globally to react and recalibrate to a lower futures price.
  • Dow component Proctor & Gamble (PG) was either misquoted or mis-priced much lower than it should have been. (Cramer notices this on the video.)
  • The market makers on the NYSE shut down for a few minutes to pause and reflect on the day’s previous 3% fall in prices. This sent existing sell order to smaller exchanges which couldn’t find enough buyers and thus prices fell dramatically.

I bet you thought that was it. But wait there’s more!

  • There were fears over the European sovereign debt crisis and the crashing Euro.
  • Related to the European crisis were images on TV of Greek citizens rioting because of the new fiscal austerity measures placed upon them.
  • Computers trading with each other in fractions of a second all simultaneously decided to sell (similar to the October 1987 market crash). This isn’t so improbable as you might expect, because most of those system’s algorithms (“algos”) were programmed by a similar set of computer and math genius who went to similar schools and were taught similar economic and financial theories.
  • And finally, my favorite: The whole affair could have been orchestrated by TPTB (The Powers That Be) on Wall Street to fleece profits from the masses (triggering stop loss orders at low prices) AND scare Washington into diluting the Financial Reform Bill being debated on Capital Hill that very day.

Here’s what should bother and scare us:

First, no one knows what caused the crash.

Second, an incredible amount of wealth, greater than some nations’ GDP, vanished into thin air over 15 minutes. How safe and secure should we feel?

There are even other possible issues which could have caused this crash and they should cause us to thoroughly examine and rebuild our financial system to be better able to absorb shocks.

Perhaps we’ll find that, like most catastrophes, it was a combination of errors and systemic issues that caused the 10% intraday stock market plunge. The stock market could handle and has handled issues in the past of similar magnitude to those listed above. However, if a few of these occurred during one day, it is doubtful order could be maintained with the current systems in place.

P.S. Does anyone still believe in the efficient market hypothesis and that stocks are ALWAYS perfectly valued?

How about the theory that “there is a buyer at every price point?”