What's Wrong With This Picture?

To be sure, market volatility isn’t new. Plunges in stock prices that start out of the blue have indeed occurred in the past. And the idea that investors can lose billions of dollars in the blink of an eye is simply part of the game on Wall Street. However, what is new this time around is that nobody really knows why the record point plunge occurred on Thursday.

I have been investing “other people’s money” in the stock market for nearly 30 years. Thus, it usually takes more than an intraday dip to give me pause. But to be honest, the fact that the reason for the plunge isn’t clear yet and that everyone is saying the systems worked perfectly on Thursday is very disturbing.

Tell me that an outage occurred, that the system crashed, that there was a mistake made, or even that a hacker broke in and had his way with the markets. Frankly, I’m okay with any of those explanations. But to be told that the Dow can dive 1,000 points and that everything worked swimmingly, well, this is simply unacceptable from where I sit.

To the retail investor, who diligently employed stop-loss orders only to see them executed at ridiculous levels, this type of activity has to feel a little like a financial hijacking. Even to the professional trend follower who may have decided to “sell first and ask questions later” during the plunge, the activity must have felt like a mugging.

So, what went wrong? How did this happen? And most importantly, can it happen again?

The NY Times is reporting that a government official directly involved in the investigation said that as of Friday, regulators had not yet been able to determine the exact cause or completely rule out any of the widely discussed possible causes of the market’s gyrations.

However, it is important to note that the Times says regulators are moving away from the ‘fat finger’ mistake theory.

Which leaves me to ask how the heck any computer algorithm could be allowed to push Accenture (ACN) from $41 to $0.01 in 15 minutes. And more importantly, how in the world is anybody supposed to invest in a stock market where the Dow can drop more than 1000 points in a “New York minute?”

The WSJ explains that it was a very large order to sell Procter & Gamble Co. (PG) that got things rolling at a little after 2:40 p.m. The market was already down nearly 200 points on the sovereign debt mess and worries about Greece. But with no news, the market then plunged, with the Dow ultimately diving nearly 1000 points.

The Journal reports that this sell order for PG was sent to the NYSE. But apparently, the order caused a log-jam in trading and suddenly, P&G shares plunged about 35%. All thanks to the wonders of electronic trading – or so we’re told.

On the NYSE, whenever a stock begins to dive, circuit breakers are tripped and trading is slowed down in order to allow human market makers to come in and restore order. But it appears that as this “slowdown” occurred on the NYSE, the computers automatically moved the sell orders to other electronic exchanges (so the orders could be executed faster).

The selling pressure created in these less-liquid electronic exchanges was then exacerbated by other computer-driven trades – all of which led electronic traders to automatically pull back their bids.

The WSJ reports that a with the Dow Industrials down about 500 points, a big high-speed trading firm, Tradebot Systems Inc., stopped trading altogether in order to limit its losses and that other high-speed firms apparently followed suit.

In theory, this meant that there was literally no one (human or otherwise) to take the other side of trade on these high-speed electronic exchanges.

Back at the NYSE, there were no trades done in PG for nearly two minutes. However, given the panic that was occurring in the market, the sell orders continued to flood in. And when the orders didn’t get filled on the NYSE, the computers just kept pushing the orders onto the electronic exchanges.

So, despite the fact that the electronic exchanges were basically pulling bids in rapid fire fashion, the computers continued to seek out the next available bid for their sell order, which in some instances was down at a penny.

The CEO of NYSE Euronext Group Duncan Niederauer told CNBC that everything worked fine on the NYSE exchange and suggested that it was the ‘black boxes’ that were to blame. Niederauer said that there were no errant trades on their exchange Thursday, that the volume on the stocks in question was VERY light on the NYSE, and that they have stock-by-stock circuit breakers in place to help avoid just such an event as was seen Thursday afternoon.

Niederauer told CNBC that Accenture and the other stocks involved did NOT trade at $0.01 Thursday on the NYSE. He says these trades were done away from the NYSE, where human market makers stand ready to make a bid at all times (even if it takes a minute or two).

On the other side of the argument, Robert Greifeld, the CEO of Nasdaq OMX, placed the blame squarely on the NYSE by suggesting that market makers didn’t do their job. Greifeld told CNBC, “Stopping for 90 seconds in time of crisis is exactly equivalent to not picking up the phone.”

So there you have it. Thanks to the quest to get more and more trades done in the blink of an eye, trades that would have been done on the NYSE were pushed into cyberspace. And with the market in a panic, the computer programs pulled the bids – all the bids. The only problem is that the farther the market declined the more pressure there was to sell. And with nobody home (or willing) to take the other side, the computers seeking bids appeared to find zero in a big hurry.

While the explanation of how this event occurred does seem to make some sense, it still boggles the mind that it happened, out of the blue, on a Thursday in May. So to help put things into perspective, we thought it might be good to understand the actual quantity of trades that were attempting to execute during the panic.

The Times reports that the BATS Exchange, a large electronic exchange, actually rejects orders if the price is more than 5% or 50 cents away from the last completed transaction. According to a spokesman for BATS, between 2:40 and 3 p.m. on Thursday, BATS PREVENTED more than 47.6 million orders from executing, which amounted to more than 95% of all orders during that period.

Think about that for a moment. BATS says they prevented 47.6 million orders from executing during a 20 minute period. So, imagine what would have happened if they hadn’t!

The goal of this report is to try and shed some light on how business is done on “the street” these days and how