Wall Street and SEC to Investors: “It Wasn’t Us, but We Will Fix It”

Wednesday, May 12, 2010

Wall Street and the SEC have identified two culprits:

  1. High-speed, computerized trading – done by someone, somewhere. They’re not sure who or when or why, but they know it was the main cause
  2. New York Stock Exchange (NYSE) – “What? But weren’t they the only ones trying to bring order to the markets?” The “popular” Wall Street opinion is that the NYSE, by slowing trading, “forced” the trades to be handled elsewhere, thereby making the situation worse. “Elsewhere” is the other exchanges and trading systems who decided to continue trading, regardless of price level.

Wow! If that doesn’t unnerve investors, I don’t know what will. Before suggesting ways to take advantage (and take cover) in today’s Wall Street, we need to go over some key items to know and understand.

Note (1): I know this is a lengthy write-up, but I hope you can spend time with it. There are four items that I believe are important to know, but are not covered well by the media. Rather than spreading them out over the next few days, I decided to combine them here, so that we can then move on to actions.

Note (2): When I wrote my previous three write-ups, “Wall Street Hits Air Pocket – Part 1, Part 2 & Part 3,” I fully expected we would know all details of what happened last Thursday. I had thought that one or more hedge funds, perhaps offshore, sold futures, setting automatic selling programs in motion. There is mention of one such fund placing a small order, but that’s hardly a believable beginning of the snowball effect that occurred. Now, the SEC and Wall Street seem relieved to move on, forgetting about causes and focusing on curing the symptoms.

1. When Wall Street says, “We’ve got liquidity,” say, “Show me the bid”

The non-NYSE exchanges and trading systems say they stayed open. The problem was, the buyers had gone home. Investors placing a market sell order just as the NYSE imposed a 90-second trading lull to protect investors from unfair pricing could have their broker send it mindlessly elsewhere even if only a penny bid was available.

Wall Street’s argument is that trading volume equals liquidity, but it isn’t that simple. Liquidity is the presence of willing and able buyers and sellers ready to trade at a reasonable price. When bids dropped to unreasonably low levels last Thursday, we saw faux-liquidity. When the NYSE, after that 90-second lull, is able to assemble real traders willing to buy and sell at a reasonable price, that is liquidity in action. And that is the only way to cut off an unreasonable panic sell-off. Letting trades occur at ridiculous prices is a recipe for damaging investor confidence, thereby diminishing liquidity further.

2. A circuit breaker should be a last line of defense

Think of these situations:

  • The airplane’s cockpit proximity siren sounds with the automated voice screaming “PULL UP!”
  • Nuclear control rods are automatically shoved into an overheated core, stopping a reaction that threatens a meltdown
  • The airbag deploys as the car hits a tree

We want all of these systems in place to prevent a real disaster. However, we hope never to experience any of them. They all represent last lines of defense in case normal caution, care and sound procedures fail.

So, too, for a stock market’s “circuit breakers.” Installed at the NYSE in 1988, following 1987’s computerized trading driven crash, they were meant to stop a stock market meltdown. The depth to which the stock market can drop before they trip shows they were not meant to substitute for properly managed trading systems.

Below are the NYSE’s circuit breaker rules for this quarter. (The Dow Jones Industrial Average (DJIA) is the “stock market” measure.)

Remember, these are DJIA moves. Nasdaq and small stocks outside of the DJIA 30 stocks – in fact, any individual stock – can have a significantly larger move. So, the SEC’s action of calling together the various exchange/trading system heads to coordinate circuit breakers can now be seen as a weak response to a serious problem.

Note: The reason for focusing on price drops and not rises is “fear.” It is easier to frighten people than it is to reassure them, so measures are needed to prevent panic – just like making it illegal to yell, “fire!” in a crowded theater.

3. Nasdaq’s plan: Execute trades, then disallow those deemed “extreme”

Unnerving is Nasdaq’s announcement that trades at “extreme” prices are being canceled. They define “extreme” as being at a price less than 60% of the previous close. (Sold out at a one-day 39% loss? Too bad.) Stopping such trades from being made in the first place is the right policy. Doing that would have allowed getting back to normal trading and pricing more quickly, and there would be no need to set arbitrary trade reversal limits. (An additional problem is what the investor on the buy side of a reversed trade did with the purchase. If it was sold when prices recovered last Thursday or Friday, then the investor not only lost the gain, but also is exposed to further price rises as if the stock had been sold short.)

4. Short-selling’s lack of restraints – gasoline for the fire

I haven’t seen short-selling discussed as a serious problem in Thursday’s air pocket, but it could be very destabilizing – yet legal. This is another area where the SEC has been lax. By not controlling the ability of short-sellers to drive a stock down, they are allowing an old Wall Street game to be played: Sell fast to unnerve investors and create fear-based selling at low prices – prices at which the short-seller can make repurchases and, thereby, earn sizable profits.

Here is the SEC’s current short-selling proposal (from my write-up, “The Three Sides of Financial Regulation: Rules, Guidelines and Saving Face,” March 4, 2010).

“The SEC’s proposed new short-sale rule is … clearly a poor substitute for the previous 1938 uptick rule that the SEC dropped in 2007. Their rationale for preferring this new rule is that it is less difficult to administer. That reason is incorrect and lacks common sense, plus the new rule misses the goal – it allows short-sellers to drive a stock down 10% before the new rule kicks in. But, with Wall Street firms affected by the rule nodding ‘yes,’ it will likely carry, allowing the SEC to say it has taken action with a new, ‘modern’ rule to protect investors.”

So… In carrying out our investment plans, we need to be cognizant of these effects on trading and pricing. Although the current structure has flaws, we can avoid its adverse effects and even use it to our advantage.

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May 2010