David's Macro Blog

British humor we can all understand.

Somehow this seems to explain the situation better than CNBC. Why is that?

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

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?”

Humor only works when there is truth embedded within it.  This works because while it is humorous, the truth is evident.

“You want the truth? You can’t handle the truth. Son, we live in a country with an investment gap. And that gap needs to be filled by men with money. Who’s gonna do it? You? You, Middle Class Consumer? Goldman Sachs has a greater responsibility than you can possibly fathom. You weep for Lehman and you curse derivatives. You have that luxury. You have the luxury of not knowing what we know: that Lehman’s death, while tragic, probably saved the financial system. And that Goldman’s existence, while grotesque and incomprehensible to you, saves pension funds. You don’t want the truth. Because deep down, in places you don’t talk about at parties, you want us to fill that investment gap. You need us to fill that gap.

We use words like credit default swaps, collateralized debt obligation, and securitization? We use these words as the backbone of a life spent investing in something. You use ‘em as a punchline. We have neither the time nor the inclination to explain ourselves to a commoner who rises and sleeps under the blanket of the very credit we provide, and then questions the manner in which we provide it! We’d rather you just said thank you and paid your taxes on time. Otherwise, we suggest you get an account and start trading. Either way, we don’t give a damn what you think you’re entitled to!”

Source: StatsGuy – Baseline Scenario.

Can good economic times last forever? Is it impossible to have “stable” economic growth?

This is the argument presented in Barry Ritholtz’s post: Galbraith: Financial Stability Creates Instability

Here are the essential points of the article.

• When the economy is good for a long time, people then think the good times will continue indefinitely so they take extra risk (e.g. debt).
• This additional risk eventually sows the seeds of the end of the economic expansionary period.

For example, during the 2000 real estate bubble, housing prices were thought to only go up, therefore the logical conclusion was for everyone to buy as much real estate as possible (by using financial leverage or debt) since this was an easy road to wealth.

Of course this speculation led to massive over construction of residential and commercial real estate. The resulting overcapacity caused falling prices which, as we now know, completely destroyed our financial system and the economy.

Interestingly, classically accepted econimics says that the economy can remain in a steady state – yet it never does, does it?  Ritholtz’s article explains what really happens.

Key Quotes

McCulley was referring to economist Hyman Minsky’s concept that long periods of stability cause people to take on ever more debt and ever more risk, leading to a gigantic meltdown.

Systemically-speaking, the Ponzi phase is one of risky behavior crowding out prudent behavior in a world free of regulatory controls. If risky behavior is temporarily rewarded with profit and this temporary period is long enough, then risky behavior wins and drives out good behavior.

Think we’ll remember this during the next bubble?

Related Posts

• What Bubble Are We In Now?
• Market Cycles: From Euphoria to Despair (and Back Again)