Thursday’s 15 minute crash; Kotok’s polemic; Art Cashin’s wisdom May 8, 2010, David Kotok, Chairman and Chief Investment Officer
America’s stock market turmoil scared the “H” out of everybody this week. Part of it was a serious 8% (so far) correction which was long overdue. Markets do not go up or down in straight lines. This one has been in a strong uptrend since the March 9, 2009 bottom. The market’s correction started from an interim top on April 26.
In the midst of this correction we witnessed a 1000-point drop of the Dow. Most of it occurred in 15 minutes in the middle of Thursday afternoon. The subsequent 600-point 15 minute reversal only complicated investors’ perceptions. This bizarre market behavior leaves them quite unsure of the future.
American’s confidence in Wall Street was already low. It is now eroded even more than before. Thursday’s drama comes on the heels of the last three years of financial-system failure in the United States. It piles on the sequence of Countrywide and WAMU, Lehman, Fannie, Madoff, Goldman, etc. Ugh! What a blotch on American history!
In Thursday’s sell-off we saw transactions that made no sense. I personally witnessed the trading in an ETF that is composed of an equal-weighted basket of the 500 stocks in the S&P index. The symbol is RSP. It traded from 40 dollars a share down to 10 in a straight line. Of course that price was not due to any accurate valuation; it was an error. It was driven by electronic interfaces and did not involve humans. It was later rescinded. The New York Stock Exchange invoked a procedure called the “Clearly Erroneous Execution Rule.” It permits the exchange to cancel trades of this type. There is no appeal from their decision.
The NASDAQ canceled trades in 281 securities. 193 of them were ETFs, according to Matt Hougan of Index Universe. Matt is a recognized expert on ETFs.
Let me be clear. I do not want to single out Rydex and RSP. Nearly all ETF sponsors had canceled trades. For example: iShares, Wisdom Tree, SPDR, and Claymore were among the list of the 193. The key takeaway is that the arbitrage mechanism and creation unit system of the ETF process failed miserably for those investors who do not understand it.
This was a warning to ETF investors who use stops without thinking about them and who trade ETFs without comparing the price to an accurate estimate of the specific ETF’s net asset value. Simply put: if you do not know what you are doing, you are playing with fire and can get burned. Many did on Thursday.
The turmoil on the floor of the stock exchange was enormous. Veteran Art Cashin of UBS described it in his daily market note that he sent out on Friday morning. Art is an icon and has wisdom from his years of experience. He is also one of the most respected, forthright and candid people in the business. I asked Art for permission to share part of his daily letter with our readers. In it he describes his personal experience on the exchange floor last Thursday. Excerpts follow, and we thank Art for letting us quote him here.
What Happened Yesterday? How It Looked From Ground Zero – by Art Cashin, Friday morning, May 7, 2010
“The stock market opened wary and a bit nervous yesterday. They were still shaky about the scenes presented in the streets of Athens in the prior two days.
Shortly after the opening, Mr. Trichet ended his ECB press conference. The sense was that he had punted the Greek problem back to the nation states of the EU. If the ECB was adopting a “not my problem” attitude, the euro didn’t like it at all. As the euro weakened, further pressure built on U.S. stocks.
Around 10:00, the bulls tried to circle the wagons. The attempt was brief and ineffective. Stocks quickly rolled over.
Prices moved lower and the Dow slipped to minus 150.
In early afternoon, the Greek protestors, who had surrounded Parliament, hoping to prevent the vote on the austerity package, began to disband. As they did so, they began to confront the police.
Around 2:00, the scene in Athens began to turn more fractious. TV screens across the floor (and across America) were filled with scenes of police wading into pockets of riotous protestors. Each foray was marked by audible reactions on the floor.
Bids began to cancel all around. The level of selling picked up and prices moved steadily and sharply lower – down 250, then 275; 325; 375; 400 then down 450.
Around 2:40, the selling grew very intense. Prices began to cascade lower in waterfall fashion. The Dow seemed to fall in 50 point increments. At this point, we should talk about structure.
The NYSE market model has some built-in safety checks. They are somewhat like the speed bumps you might find around a school zone. They are not intended to stop the car, just to slow it down enough to prevent a serious accident. Trading is slowed very slightly by those protective speed bumps, allowing better reaction time and attempting to inhibit a rush over the cliff.
Some of the players, however, tried to get around the NYSE speed bumps. To do that they sent their sell orders to other, thinner markets.
One of the examples cited in the press was Proctor & Gamble (PG). The stock was trading on the NYSE at 56. The boys who circumvented the safety speed bumps were selling PG at 39 in other thinner markets. Some sold into bigger air-pockets with 40-dollar stocks trading at a penny or less.
When the sellers saw they had rushed to sell at inferior prices (how could I sell PG 17 points below the NYSE last sale??), two things happened. First, you stop selling – immediately. Second, you try to buy back some of that stock you just sold at “give away” prices.
That kind of action is what caused the Dow to drop 600 points in a matter of minutes and completely reverse in a similarly brief period. A 17-point price gap between ticks in PG would result in a 136-point move in the Dow. That’s just from one stock.
Another assumed factor in the zany trading was thought to be a possible trader error. One, two, or even three different firms were rumored to have hit a bad button and sold more shares than intended. The media suggests it was a typo error – instead of entering “M” for million, they typed “B” for billion.
That’s highly unlikely. A more plausible explanation is that many trading desks have computers pre-programmed to limit key strokes. Instead of hitting three key strokes to sell 100, you teach the computer to “assume” the “00”. That allows you to hit a single key “1” which is then translated into 100 shares. Not much of an error if you’re selling 100, but if you try to sell 1 million, those two invisible zeroes change your order into 100 million. That’s a market mover, especially if you’re selling a basket rather than one stock.
The rumors of “trader error” could not be confirmed but they were, and are, pervasive.
One other oddity occurred after the close of business. Several venues decided to cancel a variety of those “outlier trades.” Under their rules, they can announce a trade void, and participants often have no right to appeal.
So, if you bought XZY at “bargain” prices at 2:43 and then sold it much higher at 3:30, then at 4:30 your buy order had been canceled. Your sale is still good, however, so you are now, accidentally, net short, at what looked like a good price but now looks like a bad one.
That could bring some buy interest this morning as folks seek to cover these accidental shorts. It all depends on how pervasive the cancellations were.
Another factor could be the rumored trader error. If it occurred, did they cover by the close? Did they hedge overnight? We may know on the opening.”
Art wrote about PG as his example. Note his reference to “baskets.” ETFs are a version of a basket. At Cumberland we only use ETFs in the stock markets. We do not trade individual stocks for many reasons. Art’s example about PG is one of them. We did not participate in the freefall on Thursday. We did not have any trades cancelled. We do not use stops in our ETF trading for the reasons outlined above.
We again thank Art for the lesson and his wisdom.
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