Computerized Trading Won’t Change Capitalism’s Casino
In 1967 financial writer Jerry Goodman (who assumed the pen name “Adam Smith”) published “The Money Game.” It told of Wall Street’s wild and woolly ways in the “go-go” 1960s. It was a terrific book, but not the first of its kind. There have been many others, dating back to 1688 when Joseph de la Vega wrote “Confusion de Confusiones,” describing the antics on the Amsterdam stock exchange. The moral is simple: Stock markets tend to be wild.
Remembering this lesson may help to demystify the latest Wall Street scare: computerized trading. Somehow computers are supposed to be taking over the market. They’re blamed in part for the huge 86.61-point drop in the Dow Jones Industrial Average on Sept. 11. The computers (it is said) deluged the market with sell orders to fulfill preprogrammed trading strategies. What emerges is the specter of a machine-driven market collapse and the unsettling possibility that it might trigger a broader economic slump.
Treat these catastrophic visions skeptically. What makes the stock market edgy today is not computers, but an uncertain economic outlook. Since August, 1982, the market has experienced its greatest rally since World War II: a rise of more than 125%, reflecting inflation’s decline and a strong economic recovery. Many investors now fear, perhaps inconsistently, both higher inflation and lower economic growth. There’s no consensus on Wall Street. “Stay cautious,” advises Merrill Lynch. But Goldman Sachs says: “The bull market expansion is intact.”
Computerized trading is a new--and not necessarily more dangerous--expression of the stock market’s habitual crowd psychology. Contrary to popular impression, the computers aren’t on automatic pilot; they don’t spontaneously decide to buy or sell stocks. The computers simply spot relationships among various stock prices that, according to preprogrammed investment strategies, indicate that trades should be made. Investors and professional money managers still decide whether the buy or sell orders are actually executed.
It’s doubtful whether this new form of trading will fundamentally change the market. In every era, there are fads, and speculative binges that, in retrospect, inspire gawking disbelief. In the 1960s, stocks of conglomerate companies became wildly overpriced; in the early 1980s, it was hi-tech companies. Generalized selling panics don’t require computers. The market’s decline Sept. 11 (4.61%, as measured by the Dow) is surpassed by declines on May 28, 1962 (5.71%), and Oct. 28, 1929 (12.8%), that occurred without computers.
As the newest fad, computerized trading represents the effort of institutional investors--pension funds, mutual funds and insurance companies--to coordinate trading between stocks and stock index “futures.” The index futures, which have been available only since the early 1980s, enable money managers to hedge their stock portfolios without selling all the underlying stocks. The futures allow investors to bet whether the market will rise or fall.
The risks arise from institutional investors’ huge market presence; they account for two-thirds or more of trading on the New York Stock Exchange. If many money managers trade the same way, an avalanche of buy or sell orders could make stock prices more erratic or trigger a panic. On Sept. 11, an initial stock decline prompted investment managers to sell stock index futures. The sales depressed futures prices. Then other investors--spotting a gap between stock and futures prices--sold stocks and bought futures. The idea was to profit from the temporary price difference. But the stock sales then pushed stock prices lower, perpetuating a vicious circle. Or so it’s said.
The Securities and Exchange Commission is studying whether this happened, but even if it did, it doesn’t mean that the market has changed fundamentally. Studies by Salomon Brothers Inc., the investment banking firm, indicate that stock market prices are no more volatile in the 1980s than in the 1970s. Computerized trading may simply be a new path to the same old result.
Broad moves in the stock market typically reflect changes in the economy and do not cause them. At most, the 1929 crash only triggered a business downturn. Other problems (including mistakes of government policy) transformed the downturn into the decade-long Great Depression. As for the stock market’s sharp decline in 1962, it was followed by a stock market boom and did nothing to disrupt what turned out to be the longest postwar economic expansion.
The stock market is capitalism’s casino: a betting parlor on the future. Stock markets are erratic because the future is unpredictable. This is as true now as it was three centuries ago. In 1688, Joseph de la Vega said stock prices rise or fall for three reasons: “conditions in India, European politics, and opinion on the stock exchange itself.” But because stock exchange opinion was so fickle, he added, the first two might not matter.
