'Fat Finger' Theories Aside, Members Are Advised to Stay on Track
Huddled in a room last week, SEC Chairman Mary Schapiro met with the leaders of the six exchanges to get to the bottom of what caused unusual trading activity and enormous stock market selloff on May 6.
"As a first step, the parties agreed on a structural framework, to be refined over the next day, for strengthening circuit breakers and handling erroneous trades," Schapiro said after meeting with the New York Stock Exchange, NASDAQ, BATS Exchange Inc., Direct Edge, International Securities Exchange Inc. and Chicago Board Options Exchange as well as the Financial Industry Regulatory Authority.
On May 6, the Dow Jones Industrial Average dropped 9.2%, which was considered to be the steepest fall since the market crash of 1987. As a result, nearly $700 billion was wiped out from equity markets over the course of a few minutes leading to panicked sell of orders.
Scott Powell, CUNA Mutual Group general account, managing director, said there were a number of things "when taken together, spun the trading systems into a tornado that fortunately recovered rather quickly." One factor was the high-volume, high-speed flash trading algorithms that try to skim tenths and hundredths of pennies on trading opportunities and are conducted only by very large Wall Street institutions, bank proprietary desks and hedge funds. The decimalization of equity pricing helped all of this along, he added.
"The creation of 'dark' pools, where trades are sent electronically on an undisclosed basis and the prices are only reported after the trades are conducted" was another culprit, along with "the tremendous short-term trading mindset that dominates trading volume, with its commensurate computerized models and large arrays of buy-and-sell limit prices that are attempted to be matched electronically versus the use of the floor specialist," Powell noted.
Still, that remarkable, frenzied day was not surprising if one takes a look back at history, Powell said. After each of the five major U.S. stock market bottoms, with the exception of 1932's, there was a significant recovery that tended to flatten out so that three years later the cumulative stock market gain from each bust converged at more than 60%. Powell said, "We already advanced 75% after just 13 months, with market levels and valuations running way ahead of underlying economic and individual company fundamentals with the resumption of normal growth conditions still facing significant headwinds."
"The 1932 exception saw the stock market advance 100% after being up nearly 180% 15 months out. But you have to remember that the 1932 bottom resulted in a 90% loss from the October 1929 peak," Powell said. The other major bottoms weren't as severe on a peak-to-trough basis ranging from negative 25% to negative 55%, he added.
"Bottom line, history tends to rhyme, especially when markets are at their extremes." Powell said.
Credit union members should consider reviewing their investment account allocations, "but not take the approach of sell now, ask questions later across their longer-term holdings, as this can be quite damaging to longer-term values and returns." The global relief rally on May 10 saw the markets come close to recovering what was lost over the previous week. Over longer time frames, investors tend to pour money into equity markets near market highs and sell indiscriminately during market downturns as seen in March 2009, Powell said.
"Selling some or all of your longer term assets in a panic, only to see the markets rally strongly forward, is turning your unrealized paper price fluctuations into realized dollar losses, making it very hard to successfully compound capital over time," he said. "It is also damaging to the psyche, which can be detrimental to future decisions. One needs to decide if they are going to be a trader or an investor, as the two mentalities and perspectives are entirely different."
Powell said CUNA Mutual has long recommended that members pursue an investment and planning mentality that includes parsing their investments into three buckets: short term, intermediate term and long term.