While the cause of the “flash crash” on May 6, 2010 is still under investigation, Congress is moving quickly to pass financial reform law and the SEC has proposed regulations to reduce erratic trading.  Congress’s bill will go far in preventing another trillion dollar bailout at taxpayer expense, but the SEC regulations, in my opinion, do not do enough to protect investors from the daily havoc caused by greedy and nihilistic Wall Street trading firms.

The immediate blame for the flash crash was placed on the “fat finger” of a Wall Street trader. Supposedly, an order was entered by mistake to sell $100 billion in Proctor & Gamble stock, rather than $100 million.  This erroneous trade was allowed to execute, causing a cascade of lower prices across the board.  After 20 minutes, prices reversed course and shot upward.  In half an hour, the DJIA had traveled over 1,000 points round-trip. 

Personally, I doubt the “fat finger” explanation.  An order entry error can be corrected in seconds or split seconds, it does not require 15 minutes.  I believe the trade entry was intentional, and was done either out of greed, the most likely explanation, or in an effort to alert Congress and the SEC of the dangers of under-regulated trading and high frequency “black box” trading. 

High frequency “black box” trading is a type of computerized trading which uses sophisticated data analysis and high speed trade execution to profit from small discrepancies in financial markets.  It is called “black box” trading because, once the computer has been programmed to recognize the discrepancies, the trading is done automatically without human intervention.  In the book The Quants, Wall Street Journal reporter Scott Patterson describes how Wall Street has been taken over by math and physics PhDs using computerized trading programs to generate enormous profits.  And in the book A Demon of Our Own Design, Richard Backstaber, one of Wall Street’s original PhD programmers, ascribes every market crash since 1987 to these programs and their trading of derivative securities.

The fact is that lack of regulation has allowed Wall Street at times to morph into a casino where value and common sense can be overruled by mindless machines seeking instantaneous profit.  The machines do not care one whit if they rattle the global financial system, so long as they rack up consistent profit on the way up or down.

I am working on a letter written to Treasury Secretary Geitner and SEC Chairman Mary Shapiro commenting on the proposed new regulations to reduce stock market volatility.  I suggest additional measures to protect small investors from greedy trading firms and discourage ultra-short-term trading.  The SEC appears committed to reducing wild daily swings in the stock markets but it may take some time to achieve this, and regulations may evolve over time.

Current Market & Economic Analysis

The short-term trend in the stock market turned negative on May 6 when the DJIA closed down 348 points to 10,520.32.  A rally took the DJIA to 10,896.91 on May 12, but quickly failed and a closing low was set on Wednesday, May 26 at 9,974.45.  From top to bottom, the current correction has taken the DJIA down by 10.98% in 30 days.  All the major indexes closed on May 20 below their 200-day moving averages.  This has turned the mid-term trend lower and triggered institutional selling by technically minded fund managers.

In my last blast, I noted that the May – October time frame is historically the worst six months for stocks.  While I warned of the risk of another market meltdown in time, I thought we would enjoy a period of stability for a while.  I obviously misjudged the moment.

The problems of Greece and the Euro-zone remind me a lot of the sub-prime mortgage crisis as it was beginning to unravel three years ago.  At first, it was only a handful of sum-prime loans.  Then, as real estate prices began to tick down, delinquencies started going up.  Over the next two and a half years, defaults and foreclosures mushroomed and the crisis spread throughout the world, bringing down Lehman Brothers, Bear Stearns, and Iceland, and forcing the takeovers of AIG, Washington Mutual, Merrill Lynch and others. 

One month ago it appeared that the problems of Greece would be contained, and the European Union would solve their problem just as we solved ours, by printing money.  That still appears to be the case, but I fear that Greece may be only the first European country to fail.  Spain, Italy, and Portugal wait in the wings with their own deficit problems.  Two years from now, the European Union may be much smaller, or no longer exist.  It remains to be seen how these developments will unfold, but financial markets generally do not appreciate uncertainty.  Recent action in stocks and commodities seem predictive of a “double dip” global recession.

The brutal market decline of 2008 taught an important lesson to central banks and financial regulators around the world:  rapid action is necessary to maintain market stability and investor confidence.  With that lesson fresh in mind, I am hopeful that we will not experience a global contagion and a nightmare repeat of the October 2007 – March 2009 stock market collapse.  Nonetheless, caution is certainly warranted.

There is good news inside the bad news, however.  Recent price declines have brought valuations down across the board. There is talk again of deflation, and shares of natural resource companies have been hit hard.  Yet demand from China persists, and China is sitting on $1 trillion of foreign currency reserves.  The Chinese need oil and base metals to build their infrastructure and fuel their economy.  They were active buyers of natural resource companies in 2008 and 2009, and I believe they will put more cash to work in this area to take a

dvantage of bargains.

Many companies that pay good dividends are now priced at big discounts.  Energy, pipeline, industrial, and health care companies are all on sale.  If the recession becomes reality, money will flow into basic consumer stocks as well.  Dividends of 2% to 7% are available from a variety of reputable companies in these sectors.

Trading remains volatile both up and down.  On Thursday, May 27, 2010 the DJIA was up 286 points or 2.9%.  Today, May 28 the DJIA closed down 122 points or 1.2%.  While the major stock indexes may set new 2010 lows in the coming weeks, I also believe that we will not experience the extreme and irrational pricing of 2008-2009.  If panic selling in stocks does occur this summer, it will likely represent an excellent entry point for long-term investors who can rise above the short-term volatility.

Interest Rates

The 10-year Treasury note closed Friday, May 21 with a yield of 3.24%, and the three-month Treasury bill pays just 0.16%.  The weak economy will likely keep short-term rates low, and the volatile stock market may keep longer-term Treasury yields down.  These safe investments offer very little reward.

Select short-term corporate bonds continue to look attractive, however, with yields of 4.5% to 6.5% available from B-rated issuers in maturities of 18 months to three years.  Many of these are solid companies with no history or expectation of default.  The credit markets are functioning, and healthy corporations have been able to refinance debt successfully.  Bonds generally provide investors a higher degree of safety than stocks. 

Once again, the financial world is full of challenges and opportunities.  Please contact me to discuss your unique needs and circumstances.