THE BEAR'S
LAIR Blacker
Monday By Martin Hutchinson
Last Friday was the 25th anniversary of
Black Monday - October 19, 1987 - when the Dow
Jones Industrial Average fell 508 points, or
22.6%, the S&P 500 Index fell 20.5%, and the
Nasdaq Index (which few people followed in those
pre-dotcom days) fell 11.4%.
It was a
worse one-day fall than in 1929, and was generally
expected to presage a 1930s'-style depression.
Needless to say, no such depression occurred; even
mild recession did not arrive for another three
years and the Dow Jones average was above its
pre-crash level within two years.
This
time around, we may not be so lucky.
The
extraordinary thing about the 1987 crash was that
without the stock market being excessively
overvalued, or any significant
political-economic
cause, the market fell more in that one day than
the 13.4% fall in the worst single day of the 1929
crash.
With the market far broader and
more liquid than in 1929 and with traders being
universally educated in the doctrine of its
"efficiency", such an anomaly was not supposed to
occur. Never in the course of human experience had
it done so.
That was the difference. By
1987, we were no longer in the realm of purely
human traders. Whereas human experience, with the
irrationality of John D Rockefeller buying at the
bottom of the market in 1929, was able to stem the
worst such declines, by 1987 we had already
entered the age of the machine, less philanthropic
than John D Rockefeller and totally un-shocked by
a drop of any size.
The 1987 drop was
caused by the failure of a primitive system of
"portfolio insurance" by which automated traders
used stock futures markets to limit
(theoretically) the maximum possible loss of their
portfolios.
As the futures dropped, the
portfolio insurers were forced to sell more and
more futures to preserve their supposed hedge -
while on the other side of the market computerized
arbitrageurs took advantage of the increasing
discrepancies between futures and cash markets by
placing gigantic sell orders for the S&P 500
stocks themselves.
The resulting decline
was greater than could have been created by any
human influence. Fortunately, since there was no
reason for it other than machine-based insanity,
the recovery was relatively quick and the economic
damage not great.
Since 1987, the
participation of machines in the market has
exponentially increased. The development of modern
machine-traded markets is colorfully described in
Scott Patterson's Dark Pools (Crown
Business, 2012).
From Patterson we
discover that market ethics have deteriorated, but
so has true market liquidity for non-mechanical
investors. The market has splintered into "dark
pools" in which algorithmically driven machines
battle it out like sightless triceratops in a
swamp. Also like triceratops, if disaster occurs
the signal from outside minders to stop trading is
far too slow to stop the stupid beast from
plunging into further disaster.
Thus
Knight Capital lost US$390 million in a few
seconds in August 2012 when it switched on its new
algorithmic system. Similarly, a "flash crash" a
couple of years ago caused the market to fall
almost 10% in a few minutes before it recovered.
Even more alarming than the overall
crashes were the trades carried out in the middle
of the meltdowns for one cent or $99,999 per
share. These orders are entered by the computers
to give them priority against other orders in the
order book - priority is given to orders at the
highest/lowest price, rather than to those in the
queue first.
Consequently, if these orders
are executed in a market meltdown situation, it
means there are no other players in the market at
all for a particular stock - all the other
computerized traders have withdrawn, sensing an
unstable market.
Only a tiny percentage of
the volume in US markets is now carried out by
human traders. Even the order flow from human
retail investors or almost-human institutions is
routed through computers, normally to become chum
for the piranha-robots in the trading pools (the
computerized algorithms are taught to seize retail
orders with especial glee, since they are thought
very unlikely to reflect any special knowledge
that might lead the piranha-robots to unexpected
losses).
Institutional orders are
especially disadvantaged because an order to buy
50,000 shares, a typical institutional size, will
be front run, side run, back run and jumped all
over by the algos, resulting in a sharp price move
that makes the institution's average execution
price far more unfavorable than under the old
human specialist system.
With no human
traders and machines that withdraw from the market
when turbulence arises, there is effectively no
liquidity in a crisis. Hence there is nothing to
stop prices falling to zero, picking up all the
algo traders' one-cent bids on the way.
The market imposes trading halts in
crises, but these are only likely to shut the
market altogether rather than providing a solution
to the illiquidity problem. Hence, at some point
it's likely that we will see a forced closure of
the market following a decline of an arbitrary
large percentage in the major indices.
Getting the market open again after that
closure would be a difficult task. With almost no
human traders and the machines either sidelined or
programmed to panic because of the large market
movement, it would probably take several days
before a mechanism could be organized to reopen
the market in an orderly manner. What's more, the
prices available at such reopening might well be a
multiple of 1987's 22.6% below those prevailing
before the crisis.
In 1987, the market was
able to stagger on, although at one point in the
morning of October 20 it seemed likely that it
wouldn't. Federal Reserve chairman Alan Greenspan
was able to inject liquidity into the banking
system and in the event, banking system losses
were minor. The main difficulty arose from margin
calls.
A rather smug colleague of mine,
who had received a large payout a few months
earlier from the London investment bank where we
both worked (being persona non grata to the bank's
management, needless to say no such payout came my
way) had invested it in the US market, margining
his position.
The story of his panic when
he received a call at 1:30am London time demanding
an immediate margin payment of $700,000 gave his
ex-colleagues like myself a quiet moment of
schadenfreude. Nevertheless the reality was
cruel; a 22.6% drop exposed a lot of apparently
solid fortunes to severe erosion.
Needless
to say, in today's more leveraged economy, with a
drop perhaps a multiple of 22.6%, or even a market
closure, the margin calls would spread like
lightning across the US banking system, at a time
when the banks themselves would have great
difficulty in responding because their own
positions showed gigantic losses (with their
"hedges" in the derivatives market being caught up
in the general liquidity spasm).
Of
course, Greenspan's successor at the Federal
Reserve, Ben Bernanke, would turn the Fed printing
presses on full blast, and if as in 1987 the
dollar and the US government's credit were
unquestioned that would very probably work,
limiting the losses to those medium-sized
institutions unfortunate enough not to have good
political connections.
However, there is
an even more alarming possibility. The crash I
describe would doubtless follow a period of
turbulence in financial markets generally, as did
the 1987 unpleasantness (there had been a bond
market crash about six months earlier.) In such a
case, the banks might well be sitting on large
losses on their bond portfolios, while foreign
investors would be bailing out of Treasury bonds
and the dollar.
A Bernanke attempt to open
the spigots in that event would crash the dollar,
spreading the panic from the US stock market to
the worldwide money and bond markets, and causing
the dollar to become unacceptable to international
buyers.
The unhappy five-year trajectory
of the 1918-23 Weimar Republic would be
concentrated into a few days. Imagine the worst
days of the Great Depression, when the banks
closed, combined with a Weimar level of inflation,
at least on imports, and that's what you'd get.
With stocks, bonds and cash all
effectively worthless, the US economy would then
have to rebuild itself from a state of barter,
with all debts either repudiated or inflated out
of existence. Probably a gold standard would be
necessary, as the Fed would lack all credibility
and there wouldn't be much left of the banking
system. This could be done, but it wouldn't do
much for middle-class living standards.
There are solutions to this, but they need
to be implemented. The Bernanke monetary policy
needs to be reversed, with an immediate increase
in the Federal Funds rate to 2%, still below the
level of inflation but sufficient to bankrupt all
the silly games that have depended on endless
years of zero-rate funding.
That would
de-leverage the economy, especially the banking
sector, and mean that any stock market crash
illiquidity could be remedied by more or less
conventional means, without risking a total loss
of confidence.
At the same time, a "Tobin"
transactions tax should be instituted, at a very
low rate of perhaps 0.01%. That would eliminate
the profitability of most "algo" games, which
depend on high transaction volume and low margins,
and thereby rebuild the percentage of the market
represented by real retail and institutional
investors. With this done, a one-day crash would
become limited to a merely human scale.
Although a major stock market decline
might still be necessary and indeed economically
beneficial, it would take place over the normal
timespan of 12-18 months, doubtless bringing much
elimination of "malinvestment", in the Austrian
economic term, but not risking a total economic
wipeout (unless the government did something
REALLY stupid, which is of course always
possible).
A computer-trading-driven
collapse of the US stock market would provide
material for economics PhD theses well past 2100.
Let's not give our descendants this intellectual
treat - and spare ourselves the economic agony of
living through it.
Martin
Hutchinson is the author of Great
Conservatives (Academica Press, 2005) - details
can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-12 David W Tice &
Associates.)
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