Just before last week was drawing to a close, Barry Ritholtz posted a weekend homework assignment: reading the Wall Street Journal article entitled Legacy of the Flash Crash: Enduring Worries of Repeat. Thanks for the weekend homework assignment Mr. Ritholtz!
Reading the WSJ’s take on the Flash Crash got me thinking. Just three weeks ago, I asked whether “Structural Changes in equity markets [are] leading to a loss in confidence?” And the WSJ’s conclusion, that “A flash crash could happen again because today’s computer-driven stock market is much more fragile than many believed” confirms my hunch. I think this is significant, because in looking at a recent time-line of events, the rhetoric around “uncertainty” took a major step forward in the days and weeks following the Flash Crash. Yet somehow, the focus was far more on politics than it was on any structural issues.
Immediately following the Flash Crash, investors in aggregate withdrew $14 billion from investment vehicles, including mutual funds, hedge funds, etc. This came on the heels of a run of over a full year of monthly investor inflows. What changed? In April, markets were cruising nicely to new recovery highs. Investor confidence was about as high as it had been at any point since the financial crisis began. Then on a dime, that confidence turned sour. Sure Europe was a concern. People did have legitimate worries about Greece and there was some very real selling in the market. However, isn’t a little selling only natural after an 80+% rally off of market lows? Does selling necessarily have to yield way to panic? Surely not.
Lately however, the talk from April seems a distant memory. In recent days, investors, companies and analysts alike have been talking a great deal about uncertainty. The standard narrative seems to suggest that the uncertainty is politically driven. Many are insinuating that the uncertainty of future growth, US policy, and Europe, amongst other variables all are contributing to a difficult investment outlook. In reality however, many investors seek opportunity amidst uncertainty. The greater the risk, the greater the reward, and with some good “animal spirits” kicking, this type of uncertainty in the short-run can result in some substantial winners over the long run (check out Justin Fox’s recent post on “Embracing Uncertainty,” it’s well worth the read).
On May 6th, what started as just another down day ended up as a major catalytic event. Sitting at my desk during the Flash Crash was an absolutely horrific experience that unquestionably would rattle any rational person into thinking that their money could evaporate in an instant amidst an already difficult economic climate. While staring at the level 2 quotes that day, it was even more horrifying to see all liquidity in US equity markets just disappear than it was to see the ridiculous prints in stocks like PG or ACN. What many don’t realize is that misprints or “fat-fingers” are not all that uncommon and ridiculous prints outside of the inside market are a not too infrequent occurrence.
What was totally uncommon that day was just the complete withdrawal of all liquidity from our equity markets. I was most closely watching the SPYs, the single most liquid equity in all US markets and there was nothing. Not a single bid, not a single offer. The book went blank. Prints were running off at scattered price locations, but there were no bids or offers. There had been no catalytic news come across our squawk, and in the midst of the crash, I could not help but think the worst–was there a terror attack? a new war?
The way the Flash Crash unfolded in and of itself lends itself to uncertainty. The fact that people still cannot attribute the event to any one particular cause is a discomforting reality that sits in the back of the heads of every investor and CEO. Could you imagine the thoughts of a CEO, whose job is ultimately judged by his company’s stock market performance, as his company loses nearly half its value in a matter of moments through no fault of his own? The fact that the Flash Crash left people so utterly helpless automatically triggers uncertain emotions.
Trading in the days following the Flash Crash was exceptionally volatile. But two months later I think people have realized that even if something like this were to happen again, there will still be people who want to buy good companies in this country the next day. Whether the conclusion is correct or not, people fully believe the Flash Crash to be a structural, rather than financially oriented in nature and this helps investors put money to work in the face of uncertainty. This fact makes a big difference. Following the crash, we spent 3 solid months building a base, during which time people got to look at the cold hard data. Once the bottom-up approach took hold following a slew of strong earnings reports, markets moved higher despite all the macroeconomic headwinds and perceived sources of uncertainty.