On investing and the markets

On Thursday May 6, 2010, at 2:45 PM, the Dow Jones Averages crashed.  In the space of a few moments the Dow fell 650 points.  There was no explanation at the time and apparently not one yet. Six minutes later the market recovered.  We have had many market crashes before, but none of this velocity and none of this duration.

The crash came with the backdrop of a credit crisis in Greece.  The markets were already nervous.   And then the market began to fall without resistance, in huge numbers. In later analysis, traders on the floor said that a huge $12 billion sell order in Proctor and Gamble, one of the most stable names in the market, hit the market and overwhelmed it. Then other sell orders poured in and there were no bids. Sell orders came from every direction. The market was in freefall, and there seemed no explanation. Procter fell by over 40%, by itself at one point, accounting for 150 points of the Dow fall. For a full two minutes not a single share of P&G traded on the stock exchange.

At that moment CNBC flashed a chart of Proctor on the screen, showing it was down 40%, the light bulb went off.  This could not be true!  Indeed it was not true. Jim Cramer who was being interviewed at the time correctly said, something is wrong, the system has broken down.  Buy now.  It was obvious that something was broken, but no one knew what.

In the after market analysis there were rumors of a trade error coming from a big trading house, but no one could confirm it.  Further there seemed to have been a great deal of trading by computers variously called high frequency or flash traders, dark pools, and quants.  Computer traders now account for about 60% of market volume.  I have written about this phenomenon in earlier columns and asked for an SEC investigation.  Needless to say none followed.

Flash trading occurs so rapidly, in microseconds, that it is not visible to exchange computers. The trade is complete before the exchange even knows of it. As of this writing it is not known if this was the precipitating factor in this extraordinary phenomenon.

We do know that the exchange cancelled hundreds of trades because they seemed not to have been based on actual market prices. Stocks trading for 40-50 dollars were all of a sudden trading for a penny or less. ETFs disappeared entirely because they could not price their holdings.  Within minutes, as fast as it started, the cataclysm was over. The market recovered dramatically closing down 3.2% on the day, having been down nearly 10% moments before.

A market correction is a market down 10%.  Many had been looking for a correction after an 80% plus run up, but no expected in to occur within ten minutes.

Investors still shaken by the crash of 2009 were again shaken.  Some sold. Some bought. Charles Schwab had the two highest trading days in its history, Thursday the 6th and Friday the 7th.  For each seller there was a buyer, and for each buyer there was a seller.

The SEC announced an investigation into computerized trading, among other things. Hopefully the heads of the SEC and stock exchanges will come up with some answers which will restore public confidence.

What can we, as investors, learn from this?

  1. Keep a level head.  The markets are not the economy.  On the same day this occurred, the U.S. was announcing the best job numbers we have had in years.  My DJC column recited numerous positive signs for the economy. The economy is strengthening.  The market has a job of forecasting the economy but this was not a forecast in the face of all the positive economic numbers, it was an aberration and should be treated like one.The Greek credit crisis is a real problem but the question was, would European leaders let the economic union of Europe fail because of one or even several countries’ credit problems?  To save them all would only cost 8% of European GDP.  Could they afford to lose decades of prosperity and relative peace over a manageable problem?

    Of course, the solution required collective action, and collective action is always problematic.  We have fought two world wars and a civil war because of the failure of collective action.

    The Greek problem was once smaller, smaller than AIG, but European leaders had dithered and now it was bigger.  The U.S. declined to save Lehman Brothers, which it could have done for about $60 Billion, and later paid many times that in damages.  So, there were strong reasons to act.  And act the EU did, with a nearly $1 trillion bailout package to cover all the European problems. Or so they hope.  Yes, it sets a bad precedent, but the alternatives were worse.

  2. Tune out the back ground noise.  We are investors, not traders.  We are like sailors on a ship in the middle of the ocean.  We will be tossed around by storms and gales, but if we keep our eyes on the horizon and not be distracted, we have a better chance of reaching our destination.
  3. A lot of what you hear is just noise. Focus on the essentials. As soon as the graph of Proctor was on the CNBC screen, the CNBC producers, to heighten the drama, flashed to the street riots in Athens.  When the markets closed later, down 3.2%, CNBC again dramatized the moment with riot footage.
  4. Keep in mind that long term investors have a better chance of winning.
  5. Don’t try to out smart the market.  The market will always be smarter than you
  6. Don’t try to time the market, invest long term.
  7. Successful investors buy when other people are selling and sell when other people are buying.  Remember Baron de Rothschild’s famous saying:  “the time to buy is when the blood is running in the streets.”
  8. Invest in the global economy. The diversification will lower your risk, and as long as we have peace we will be prosperous.
  9. Over eighty percent of losses in the market are self inflicted.
  10. Focus on the economy.  Focus on the fundamentals.

Follow the above simple rules and you will succeed.