As if individual investors lacked reasons to mistrust the stock market, along came May 6's gut-wrenching, 9.2 percent drop in the Dow Jones industrial average.
The rapid stock plunge—followed by an equally quick, partial rebound in which the Dow regained nearly half its losses—surprised retail investors. Days later, they are trying to digest the realization that the market action during the so-called "flash crash" has bewildered the pros, too.
"I still haven't heard a satisfactory answer as to what happened and what could be done about it," said Frank C. Boucher, who heads a financial planning firm in Reston, Va., on Monday, four days after the market's drop.
The U.S. Securities & Exchange Commission, charged with regulating the stock market, has offered no explanation. SEC Chairman Mary Schapiro met with the heads of six major exchanges on May 10. According to an SEC statement, a main part of the agenda was "discuss[ing] the causes of Thursday's market events [and] the potential contributing factors."
A U.S. House of Representatives subcommittee is expected to examine the reasons for the stock plunge at a hearing on May 11.
Among possible causes, media analysts and traders have cited erroneous trades, currency spikes, market regulations, and high-frequency, computerized trading.
"We don't know yet," says Paolo Pasquariello, who studies trading as a finance professor at the University of Michigan's Ross School of Business. Like detectives reconstructing a crime scene, regulators must embark on a long project of "forensic finance" made more difficult by the fact that U.S. equity markets have become fragmented among different exchanges and trading platforms, he says.
One sign of how confusing and complex the system has become: "There isn't even a single, consolidated database of all transactions in the U.S. stock market," Pasquariello says.
Figuring it all out and proposing rules to prevent another such event could take months. "There were a series of events that probably caused this to happen," says Adam Sussman, director of research at the TABB Group, a financial market research firm. The bottom line, though, is that nearly everyone—traders, exchanges, and regulators—have been caught unaware of a major flaw in the system. "We're not as smart as we think we are in creating a resilient, stable market structure," Sussman says.
Such events drain investor confidence in financial markets, says John Merrill, chief investment officer of Tanglewood Wealth Management in Houston. "Little by little they take away confidence that this is about investing," rather than merely trading and gambling, he says. "It is becoming more of a casino," he says, with investors thinking "this isn't how I wanted to plan my retirement."
The stock price recovery on May 7, and again on May 10, has eased some retail investor concern about the markets, says Elaine Scoggins, a financial planner who is client-experience director at investment advisor Merriman in Seattle.
"It has definitely revealed a crack in the system that needs to be corrected," Scoggins says. For now, investors are "sitting on the sidelines to see what the regulators are going to find and what they're going to do."
On May 10, the SEC said exchanges had agreed "as a first step" to the creation of a "structural framework" to address problems with erroneous trades and "circuit breakers"—procedures that automatically halt or slow trading in the case of extreme volatility. Congress may take action, too, with key senators discussing ways to address the issue in the pending financial reform bill.
Dick Grasso, the former chief executive officer of the New York Stock Exchange, told Bloomberg Radio on May 10 that "circuit breakers could have prevented a lot of what we saw last Thursday." It makes sense to tighten up regulations, Grasso said. "A Ferrari is capable of doing 250 miles an hour but we don't allow it to do that in a hospital zone."
Innovations in equity markets over the past decade have sped up trading, moving millions of transactions from the hands of human beings on the floor of the New York Stock Exchange to a vast electronic network in which most buy and sell orders come from computers. It's a new system that regulators have helped create in an effort to make markets more efficient and to lower trading costs.
The blame, then, for the May 6 stock plunge rests neither on errant traders nor on tensions over Greece, but on the system itself, Stifel Nicolaus (SF) analyst Chris Brendler wrote in a May 7 note. Regulators must now play catch-up, he says. "The evolution of trading technology and market structure over the last decade has been far too rapid for regulation to keep pace."
Steverman is a reporter for Bloomberg Businessweek's Finance channel.
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