Will A Computer Cause the Next Big Market Crash?

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This article was written over two years ago by Partners South founder, Dr. Timothy R Fussell, PHD. CNN just released a similar article on 8/14/20114.

Hi Everyone, Tim here. If you have any savings or retirement money in the stock market or mutual funds, you’ll want to read this newsletter carefully… And then decide the appropriate action for your own safety. Even if you don’t gamble with your money in the stock market, it’s still a fascinating story…and one that COULD help save you from huge financial losses in the future.

NOTE: The following is based on a true story. Certain facts were changed to protect the guilty (and innocent)

It all started on the morning of May 6, 2010. Jerry’s alarm woke him out of a sound sleep at precisely 5:55 AM. Just like always. After a quick run, a shower and a shave, he sat down for a bagel and cream cheese. As he sipped his coffee, he scanned the headlines on his laptop. All the financial markets seemed stable. April jobs report was normal. Pretty routine stuff. The only big question mark was whether Germany would vote to bail out Greece tomorrow. That was key. If that happened, it would calm investor fears and stabilize the financial markets … and make his job a LOT easier over the next few months.

“I’ll bet Germany’s vote on the Greek bailout package will be the big headline tomorrow,” he said as he kissed his wife on the forehead and headed  out the door. “Mmm hmm,” she said with a half-smile over her mug of coffee. Little did they know that Jerry would cause the big headline tomorrow. Worldwide. Jerry rubbed his hands in the 55 degree damp morning air before unlocking his black Audi S4.

It was a 37 minute drive down the I-435 “loop” to his office. He could practically drive the route in his sleep. He arrived at his  Overland Park, Kansas office at a few minutes before 7:00 AM. He loved the conservative feel of this Kansas City suburb. Jerry was always one of the first to arrive at the office and he liked getting a good jump on his workday. Managing a mutual fund  wasn’t the hardest job in the world … but he took the responsibility seriously. After all, thousands of fellow Americans trusted  their life savings to him. He was responsible for their future. He didn’t want to jeopardize their nest egg.

He started brewing a fresh pot of coffee and pushed the button that lit up his computer monitor. As he went through these morning rituals, he had no way of knowing that by the end of the day, his actions would be responsible for putting the entire world’s nest eggs in jeopardy.

Jerry sunk down in his high-backed padded captain’s chair and checked his email. He then pulled out his daily planner and mapped out his day. He circled the 10 AM weekly strategy session in red. That’s where all the managers discussed the  investments in their funds … which ones should stay, which ones to unload. It was all about managing risk. After all, Waddell & Reed, Inc. was the first company in the USA to sell mutual funds to the general public back in 1940. And it had a 73-year history of being one of the most conservative investment firms in America. It was a reputation Jerry was proud to carry on in the way he managed his fund’s portfolio.

At the 10 o’clock meeting – started precisely on time – Jerry listened as the firm’s research  department outlined the potential scenarios for the Greek debt crisis. Their conclusion was simple and straightforward. The  signs pointed to the European crisis eventually spilling over to America. They felt US markets were at risk … at least in the short run. And with the EU bailout vote in the morning, they suggested hedging against bad news rather than hoping for good news. The researchers also mentioned that the markets were already reacting negatively ahead of the European news. The Dow was already down over one hundred points for the day. Before the meeting ended, the top brass urged each fund manager to scan their portfolios for any weak spots they could purge before the Greek news hit the next day.

Jerry already had in mind what he wanted to unload. His fund had been sitting on 75,000 shares of S&P 500 futures. That purchase had carried the fund through  first half of 2010 with a nice healthy gain. But with this Greek crisis sure to simmer throughout the summer, it would be best to take those profits off the table now. Besides, it was May 6, and as his wise mentor had always said, “Sell in May and go away.” In  his years of investing, Jerry had never found that to be bad advice. But this year it seemed especially prudent.

After the meeting, Jerry grabbed an early lunch. He called his boss, Sidney, and asked if he could meet with him sometime that afternoon. He  needed to discuss how best to sell off the 75K of futures contracts he was planning to unload. They were worth over 4 billion dollars, and he was worried about the impact it might have on the market. “Nonsense,” quipped Sidney at their 1:00 PM meeting. “We’ve dumped much bigger loads of equities back into the market before. It’s pretty routine stuff for funds our size, Jerry. Don’t worry about it.”

As Jerry headed back to his office, he knew that the only thing he had to worry about now was the clock. He had  to act fast. The exchange would be closing in less than 3 hours and selling that many shares wasn’t the quickest thing to do. He could remember back in the early days of his career before computers … he’d have to phone all those trades in, or worse yet, fill out a sell order by hand for each block of contracts he was selling. A job this big would probably take him all day back then! But not today. Jerry settled into his seat and fired up the custom software the company had purchased from Barclay’s Capital for moments just like this. Jerry took his time to make sure he had all the figures right. He double-checked his math and made sure all the symbols matched the contracts he wanted to sell. Then he went into the program settings and, checking his watch, ticked the “Max Sell” box.

That told the software to sell the shares as fast as possible.The software sold the contracts in 1000 share blocks at delayed intervals. Normal parameters would spread the trade over 5 hours.

But Jerry didn’t have 5 hours. Jerry wanted to make sure all of the S&P futures were moved out of his portfolio by the end of the day. Jerry then checked another box that would change history. The field was labeled “Ignore price threshold.” It told the computer to sell each block without regard to price. Normally the computer routine would check the market price after each block of contracts was sold. If the price dipped too far, the program would pause for a while. That allowed the share price to stabilize in the market before selling the next block.

Jerry didn’t want to slow things down. He wasn’t worried about losing a few pennies on the last few trades. He just wanted to get the trade over as soon as possible.

Once he was satisfied with his settings, he glanced up at the big clock on his wall. He had it set purposely an hour ahead to match the time at the New York Stock Exchange. It read 2:32 PM. “Cutting it close,” he thought to  himself. Then Jerry clicked the “Send Order” button to start the program. And with that little click of the mouse, Jerry initiated  the wildest 20 minute roller coaster ride the modern stock market has ever seen.

Once Jerry’s program started dumping his S&P future contracts back into the market, other rival computers took notice. These computers, known as high-frequency traders, or HFTs, are computerized robot traders who buy and sell at high speed. They account for huge part of the daily trading activity in today’s markets. Initially, these HFTs started scooping up all the futures contracts Jerry was selling. But soon these robots  detected that more and more of these same shares kept flooding the market. The computers suddenly slammed on the brakes  and kicked it in reverse. They began to sell their newly-purchased contracts aggressively. This selling pressure started driving  the price of the futures contracts down … …but Jerry’s computer kept obediently doing what it was programmed to do. Sell, sell, sell. Soon other computers across the globe began waking up and noticing the unusual action…and many of them joined the  party. As more robots joined in, the frenzied trading patterns caused a “hot potato” effect. One computer would buy a block of  contracts, thinking the price was in “bargain” territory. But within seconds, the plummeting price would set off a new internal alarm that said it was time to sell. Another robot that was just getting into the game would then catch the “hot potato” and  continue the process.

At one point during the frenetic sell-off, a single block of Jerry’s future contracts changed hands 27,000 times in 14 seconds!

Soon the chaos spread from the futures market to the stock market as well. Automatic computerized robot traders began selling off huge blocks of company stock.

Large, stable, blue chip companies like Procter & Gamble saw their shares trade down as low as a penny or as high as $100K in a matter of minutes.

The rout continued until an automatic stabilizer on the exchange paused trading for five seconds. After that the markets recovered. By 3:15 PM the exhausted robots called it quits. Jerry was oblivious to it all.

As he tidied up his workspace and prepared to go home for the day, he had no idea the carnage his little mouse click had caused. As he drove home in the 72 degree sunshine of that beautiful May afternoon, Jerry pushed the button on his radio to catch the early news. The female news reporter broke in with an urgent tone: “And now this  breaking news just in … the Dow Jones dropped nearly 1000 points in a 6 minute span near the end of the trading day this  afternoon. Before the final bell halted trading on the stock exchanges, the Dow shed 348 points off yesterday’s close. Exchange officials say it’s the stock market’s worst day since the September 9, 2008 crash. Industry experts say this “flash crash” marks  the deepest single intra-day dip in the Dow’s 114 year history. The cause of the crash is unknown. We’ll have more details as they come in.” Jerry raised his eyebrows in surprise … and then smiled to himself. Apparently he had gotten out at just the right time, he thought to himself. He had protected his shareholders! In the weeks and months to come, wild speculation fueled internet blogs and financial magazines.

Their home-grown theories about the cause of the “flash crash” ranged from a CIA conspiracy … to Wall Street funny-business … to a “financial terrorist” hacker attack … and even to an alien invasion (seriously?!). For many people, the incident went by unnoticed. But it sent a chill down the spine of every soul involved in the financial services industry. It took until October of 2010 before investigators with the Commodity Futures Trading Commission released a report explaining the details of the flash crash.

They found that Waddell & Reed had not acted maliciously. In fact, they verified that the firm had executed hedging strategies of similar size previously. But the real question everyone wanted to know was this: Could it Happen Again? That was the one aspect regulators left out of their report. They gave absolutely no assurance that this “flash crash” debacle was a one-time fluke.

In 2010, many experts suggested it was very likely to happen again. And now, two years later, their suspicions have been confirmed. A new study released in 2012 shows that “flash crashes” not only CAN happen again, but that …Mini Flash Crashes Actually Happen Routinely. These micro-crashes simply happen at speeds so fast they don’t register on regular market records. But the computer experts who conducted the study say they  definitely affect market stability……and have the potential to cause an unprecedented widespread stock market crash that won’t simply recover by itself. The analysis involved five years of stock market trading data gathered between 2006 and 2011.  Researchers sorted the trading data in fine-grained, millisecond-by millisecond detail. High frequency robot trades usually occur below the 950-millisecond level. At that level, computerized trading occurs so quickly that human traders can’t even react. During the 5 year span of their study, these researchers pinpointed at least 18,520 minicrashes! The way they describe it, the entire trading system rests on a foundation of shifting sand instead of solid bedrock. This inherent instability could be the trigger that sets the next “Big Crash” in motion… …just like Jerry’s little mouse click. It doesn’t take much to start an avalanche. Just one misplaced snowflake. But once it starts, look out below. And today’s stock market is an avalanche waiting to happen. It just needs that little push.

Here’s Tim’s Solution:

I keep my money out of the stock market. I have identified strategies that form a solid financial foundation for your wealth. These strategies allow you to protect … and grow your hard-earned cash, without the risks of a market collapse.

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