It's been a tough couple of years for the individual investor, who has all but disappeared from today's market activities, primarily due to a growing lack of confidence, driven by the notion that powerful forces outside their control or awareness are in control.
What these forces are have been brought to light this week in a debate over what may have caused the so-called "Flash Crash" on May 6 when the stock market plunged 700 points in seven minutes.
After studying the May 6 phenomenon for five months, the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) finally issued their report last week. They blamed the flash crash on an algorithm that triggered a $4.1 billion sell order by a mutual fund as a hedge against an existing equity position.
What's an algorithm?
An algorithm, for those of you who avoided high school algebra or trigonometry, is formula for solving a problem using a specific sequence of steps. On Wall Street, large money managers use computer algorithms to off-set possible losses, somewhat like a card counter at blackjack tables hedges his bet by keeping track of which cards have been played.
In the May 6 flash crash, a mutual fund company applied an algorithm that led to selling 75,000 of what are called "E-Mini contracts" at a time when market volatility was rising, when sellers outnumbered buyers and at an execution rate of 9% of the total trading volume. E-Mini contracts, by the way, are electronically traded portions of regular futures contracts, something most individual investors have never even heard of.
A cause but no solution
The SEC and CFTC claim it was the fund's sell order that helped trigger the flash crash and further chided the mutual fund's algorithm saying it initiated a large trade without caring about price or time.
What the report didn't do was offer a solution to make sure something like this doesn't happen again. And until regulators do that, individual investors will continue to lack confidence in the markets and remain on the sidelines.
High frequency traders
The founder of market data firm Nanex LLC, Eric Hunsader told The Wall Street Journal that the so-called "flawed" algorithm at the heart of the May 6 crash wasn't really to blame and had actually slowed down the selling during the market's steepest decline.
Also, since the report was released a number of market experts place at least some of the responsibility on what are called "high-frequency traders" who entered their own sell orders enhancing the speed of the May 6 downfall.
Even CBS 60 Minutes devoted a segment to "high frequency" traders this week, showing how they use giant super-fast computers to execute rapid trades in order to gain a price advantage over other traders. According to the 60 Minutes report, most stock trades in this country today are made on these super computers that, apply algorithms to buy and sell orders for thousands of stocks in a split second. A key criticism is that these algorithms do this without knowing anything about the underlying value of the companies that are being traded.
Internalization
Adding to the debate, some market watchers are pointing their fingers not only at the high frequency traders but also at large brokerage firms who stopped buying and started selling. Basically, the brokerage firms stopped the automatic execution of customer orders. This is known as internalization, which typically accounts for most individual investor trades.
In this process a brokerage firm tries to match one customer's buy order with another customer's sell order and do it entirely in-house. If the firm can't make the trade, it sends the order on what's known as executing broker such as Knight Capital and UBS.
If an executing broker refuses, the brokerage firm can also sends the trade to something called a dark pool, which is often owned by his firm. Dark pools are electronic-trading operations where institutional investors can trade stocks away from the public stock exchanges. Then, if the dark pool can't execute the trade, it is sent to one of the stock exchanges. Keep in mind that all of this occurs in less than a second.
Brokerages abandoning retail customers
On May 6, some brokerages reduced executions of sell orders but continued to execute buy orders. That means they would sell shares to a retail customer but then wouldn't buy any shares from a retail customer. In an effort to deplete their own inventories of falling share prices, they dumped customer sell orders onto the overburdened stock exchanges.
According to a report in Barron's, some 20,000 trades totaling 5.5 million shares, were executed at a price 60% or more away from pre-flash-crash price levels, and were later ruled invalid. At least half those were retail orders placed by individual investors.
Most people outside of the industry know very little, if anything, about dark pools, high frequency traders or algorithms that manipulate the market in order to hedge against something that has nothing to do with underlying fundamentals such as value.
Congress to investigate
We keep hearing how congress and the regulators are going to look into these "market forces" and institute changes but we've been hearing that since the Crash of 1987, when something called "portfolio program trading" was revealed to be the culprit. What they came up with are circuit breakers that stop or slow trading if a stock rises or falls too far too fast. Look how well that worked on May 6.
Individual investors have pulled billions of dollars out of the stock market since the May 6 flash crash. Even though financial advisors will tell you one of the best ways to build your portfolio is through stocks, you first have to feel confident that those stock prices are not going to be manipulated by forces unrelated to the value of the stock. Otherwise, what's the point?
