"Computers - Have Their Power Exceeded Man's Abilities to Control Them?"

Sydney M. Williams

Thought of the Day

“Computers – Have Their Powers Exceeded Man’s Abilities to Control Them?”

May 10, 2010

Helplessness, rather than panic or fear, was the emotion I experienced at 2:45PM on Thursday afternoon, as the market evaporated, dropping 600 points in a matter of minutes. The world just doesn’t change that quickly. However, after a few moments a fatalistic calm reassured me that more tranquil voices would prevail.

The crack in the market Thursday exposed a fundamental flaw – machines have advanced faster than man’s ability to control them, or for regulators to understand them. The actual cause – a “fat finger”, an algorithmic trade gone astray, an errant high-frequency trading program, or a rogue quant – is less important than the culture that has not only permitted, but encouraged, such activity. In our capital markets, speed has overtaken deliberation; thinking has been supplanted by doing; irrationality has swamped reason. The focus on computer trading, which can take advantage of minute mis-pricings (multiplied millions of times per minute) and other automated strategies, have diverted attention from long term, fundamental investing.

To dismiss Thursday’s market collapse as nothing more than a computer glitch could have far reaching negative consequences, not just for Wall Street, but for Main Street. A few quants have found quick means of making exorbitant trading profits, by converting our capital markets into a casino; in doing so they risk millions of small investors losing confidence in those markets. Should that happen we all become losers – businesses will find it difficult and more expensive to raise capital; jobs will be lost; retirees and shareholders will see their savings dwindle. Changing the culture of a society is not easy, but the government must focus on encouraging long term investment (at the very least, capital gains should be indexed to inflation); an uncompetitive corporate tax rate should be reduced; dependency on the largesse of government, as we have seen in Greece, does not work; the concept of personal responsibility should be reasserted; punitive taxes should be levied on very short term trading profits to discourage rampant speculation.

According to a piece in Saturday’s New York Times, non registered exchanges account for more than a third of all trading. We know that on Thursday two NYSE-listed stocks (there were more, but these two stand out) – Proctor & Gamble and Accenture PLC – had dramatic declines (and recoveries) in a matter of minutes, declines that could not have reflected fundamental changes. The price of P&G fell from 61 to 39 in a couple of minutes, while, according to the Times, Accenture fell from $32.62 at 2:47:46 to $0.01 at 2:47:53! The NYSE had halted trading in both stocks, but computer driven programs automatically diverted orders to platforms where there still was a bid – platforms not subject to the rules of the NYSE. Within minutes both stocks recovered most of the ground lost, but the die had been cast.

A failure to address the root causes of a problem is akin to kicking the ball down the road, as the Europeans seem to have done late last night. In Europe, the problem is debt and a dependency on government. In the U.S., it is also debt and a focus on the very near term. The root causes of problems must be addressed which necessitates pain, or they will reappear.

In a pragmatically sensible weekend editorial, entitled “Volatility You Shouldn’t Believe In”, Investor’s Business Daily stated: “We all understand that electronic markets are here to stay. What we need, however, is an electronic market, not markets – a market that features a system of price discovery that has one set of rules for all platforms and exchanges, is transparent rather than secretive, is consistent not fractured, and is fair not privileged.”

One bright spot about Thursday’s market’s crash is that it may serve as a call to fix the regulatory lapses that allowed such behavior, and to galvanize Washington into focusing on the need to make investing (as opposed to trading) an integral part of reform. An interview by John Fund with Mark Bloomfield, CEO of American Council for Capital Formation, in Saturday’s Wall Street Journal, was informative and encouraging on this subject. It is worth reading. As we have written many times in the past, Washington should use behavioral studies to encourage savings and discourage consumption, for we are facing an onslaught of retiring baby boomers, and there is not enough money in the till. Compounding the problem, events such as what happened on Thursday cause confidence, a necessary ingredient in capital markets, to wane.

In terms of the economy, things are getting better, not quickly perhaps, but they are improving. Employment data for April (and upward revisions for February and March) were encouraging. The ECRI Index rebounded last week from a 38-week low. A widened TED spread (from 19 basis points on Monday to 32 on Friday) was noted, but remains below the pre-crisis norm of 50 basis points. S&P 500 earnings are forecast to be $76 to $80, providing – before dividends – an earnings yield of 7%, which compares favorably to a current yield on Investment Grade Corporates of less than 5%. Preliminary earnings estimates for 2011 are for a gain of 10%-15%, suggesting an 8 1/2% to 10% earnings yield. The economy is not out of the woods, and stocks over the short term always move in mysterious ways. But things are improving. Volatility is likely to remain elevated as we go through a detoxification process, but it seems a mistake to remain too bearish when the environment is depicted so negatively and chaotic. Keep in mind Laszlo Birinyi’s Cyrano principle, “If the concerns of the markets are as obvious as the nose on your face, the market and policy makers will have an amazing ability to adapt and adjust.”

In October 1938, as clouds of war were spreading across Europe, E. B. White wrote an essay, “Clear Days”. He was repairing the roof of his Maine barn and thinking of Chamberlain’s infamous September 29th signing of the Munich Pact with Hitler. Mr. White was dismayed by the Treaty. “There is a certain clarity on a high roof…One’s perspective, at that altitude, is unusually good. Who has the longer view of things anyway, a prime minister in a closet or a man on a barn roof?”

If one substituted prime ministers for quant-driven high frequency traders and Mr. White for long term investors, mightn’t that be an applicable analogy?