The past week saw lots of market activity – some of it rational, some of it not, but most of it bad. The S&P 500 index ended the week down 6.35%, which all but erases any gains for 2010. If you’ve paid attention to the headlines you know that late on Thursday the U.S. equity markets experienced tremendous volatility as the Dow Jones Industrial Average experienced a brief intra-day 1000 point decline.
There are two things going on right now. One is the overall weakness in the markets and the other is the trading glitch that occurred on Thursday. I’ll address each separately.
The equity markets were already weak Thursday when a wild swing occurred in the late afternoon and the Dow suddenly dropped 500 points in a matter of seconds. Some large, stable companies like Proctor and Gamble, 3M, and others lost 25, 40, even 99 percent of their value. Most of the steep losses were regained within minutes, and the erroneous trades have been canceled, but the whole incident is concerning. What exactly caused this movement is still unclear. The press has pointed to a possible “fat fingered” trader entering a sell order on P&G with a ”B” for billion rather than an “M” for million, but that seems unlikely and does not explain away all of the events of the day.
More likely, the volatility resulted from a confluence of events. The equity market was already down significantly and very volatile. This caused several large, computerized trading firms to scale down their activity, eliminating a natural supply of potential buy orders. At the same time a large P&G sell order came through (perhaps by mistake), overwhelming a limited number of existing buy orders. This is a common occurrence and the New York Stock Exchange (NYSE) responded as expected. They went into “slow” mode, and gave the NYSE specialists (real people) a chance to work through the order imbalance. Unfortunately, other electronic markets did not have these “circuit breakers” in place. Some sell orders that could not be executed on the NYSE, looked elsewhere and found buyers at much lower prices on other exchanges, resulting in a significant divergence between prices on various exchanges. When these aberrant prices crossed the screen, more ripples flowed through the markets.
Had trading been “slowed” down on the other exchanges, as it was on the NYSE, this divergence in pricing probably would not have been as extreme. According to the Wall St. Journal, while P&G was trading through the NYSE specialist at $56 in “slow mode,” it was traded on the NASDAQ, an electronic exchange, for $39.37.
- Is this supposed to happen? Absolutely not
- Are markets perfect? No
- Does this reveal a troubling flaw in the current system? Yes
- Will those who manage the exchanges react quickly and fix what is broken? Yes
- Does this affect our investment strategy? No
In our world, the markets are a source of liquidity. They allow us to buy or sell thousands of companies at a time with remarkable ease and at remarkably low costs. With barely any notice, we can purchase a diversified pool of over 3500 U.S. businesses for about $25. Think about that. It is truly remarkable. Conversely on any day we want to sell our pool of 3500 companies, we know we have a buyer. We may not like the price, but we know we can turn what would otherwise be an extraordinary illiquid holding into cash with one day’s notice.
So, while the markets aren’t perfect, and they can sometimes stumble and fall, as they did on Thursday, they serve us just fine.
So, what about the overall market weakness? There is a debt crisis in Greece, a huge oil spill in the Gulf of Mexico, a near-miss terrorist incident in New York City, and Nashville is under water. The real surprise is not that the markets have been weak, but that they had reached their highs for the year just two weeks ago. Underneath all this turmoil is the same mix of good news and bad news that we’ve been watching for the last year. The U.S. economy continues to strengthen, but unemployment remains high, and we still have some large systemic issues that need to be addressed in the near future. The major risks, however, are in Europe.
Across the Atlantic, European leadership is finally recognizing that Greece (and other troubled EU countries) can’t fix their problems alone. The creation of the European Union and the use of a common currency has many advantages but comes with a cost. Individual countries lack the monetary policy tools needed to manage through debt issues like the ones faced by Greece, Portugal, Spain and others. Strict fiscal controls were supposed to in place to prevent this from ever becoming an issue, but in reality, the EU let its guard down and never attained the fiscal discipline that was a key component of EU success. They now have to pay the collective costs.
Greece is not “too big to fail.” It is simply too hard to fix. The only plausible solution is the one being proposed today – a shared balance sheet approach that will allow countries with strong balance sheets to support those with weaker ones. This could make the EU more interconnected than ever, and give it the incentive to finally address some of flaws in the EU system that have been ignored for too long.