Program Trading Ignites Furor Yet Again
Wall Street’s wild plunge Monday has rekindled the angry debate over computerized program trading. But many experts say the programs are merely a symptom of a far larger problem: the unprecedented control that institutional investors have over the market.
Pension funds, mutual funds and other big money managers own the bulk of the $3.5 trillion in U.S. stocks. On any given day, they are responsible for 80% of the trading in the market. When enough of those investors decide that it’s time to sell stocks--and they all try to get out the door at the same time--it’s inevitable that the market is going to suffer a huge hit.
“We’re a herd of damn water buffaloes,” admits Peter Anderson, who heads the pension fund arm of investment giant IDS in Minneapolis. “There is no countervailing force.”
Institutions’ program trading has two main forms:
* So-called index arbitrage, the use of computers to trade stocks against stock-index futures, purely for short-term profit (buying one side and selling the other).
* The buying or selling of dozens or hundreds of stocks at the same time, simply because a money manager decides to make a big bet on the market, or against it. Computers make it easy and fast.
What’s misleading about the program trading debate, say some analysts, is that the programs are viewed as a kamikaze fleet that suddenly appears out of nowhere. In fact, the programs are always rooted in some fundamental shift in the market.
A bearish mood swept over many money managers late last week, analysts note, when the Dow Jones industrial index failed to top the 3,000 mark on several attempts and then tumbled 32.67 points on Friday. A number of disappointing corporate earnings reports--the latest from blue chip McDonald’s Corp. on Friday--seemed to change many big investors’ views of how high stock prices deserve to be. The Dow’s 450-point surge since late January has been suspect in the face of a weak economy and troubled financial system.
Monday, when the selling began, the programs clearly were leading it. Bearish traders dumped Standard & Poor’s 500-stock index futures contracts in Chicago, which represent a convenient way to bet quickly on the direction of the 500 big stocks in the index. As the contracts plunged, the index-arbitrage program traders kicked in: They started buying the contracts while selling the actual stocks in New York, because the contracts were suddenly selling for much less than the sum of the individual stocks.
By buying the cheap contracts and selling the more expensive stocks simultaneously, program traders lock in a fast profit, because the futures contract and stocks must eventually come back into equilibrium.
The collapse in stock index futures triggered a “circuit breaker” in Chicago: At 10:34 a.m. EDT, when the S&P; 500 contract was off about 12 points to about 353.00, traders were forbidden from bidding the price any lower for 30 minutes.
The circuit breaker, instituted in the wake of the 1987 market crash, seemed to work, analysts said. The halt in trading is designed to stop the cascading effect of plunging futures causing new waves of stock selling, and vice versa. And in fact, the Dow bottomed in the morning with a loss of about 100 points--roughly equivalent to the 12-point decline in the S&P; futures, about 3.3%.
The New York Stock Exchange also tried to ease the effect of program selling by requesting that brokerages voluntarily refrain from index arbitrage unless their programs were aimed at stabilizing the market.
But while some analysts credited the circuit breaker with halting the plunge by limiting programs, the same circuit breakers were in place last Oct. 13. Yet the Dow index still lost 190 points that day.
To some money managers, there is just one answer: Ban index arbitrage programs altogether, because the fast trading shifts that they fuel frighten many investors.
“I think it should be illegal, period,” said Ken Heebner, who runs $2.5 billion for Capital Growth Management in Boston. He argues that program trading is the same as insider trading. Brokerages, Heebner says, make money using programs by playing index arbitrage games when they see their own clients gearing up to buy or sell huge amounts of stock.
Heebner’s charge is that the brokerages are “front running” the market, trading off information that only they can see at that given moment.
But banning index arbitrage wouldn’t solve the larger problem, other experts argue: Big investors’ use of computers to simply dump many stocks at once, a strategy that has nothing to do with stock futures or index arbitrage.
When big investors decide they want to sell stocks--for whatever reason--they don’t want to sell in pieces over a few days, says Peter Grennan, stock-index futures chief for Shearson Lehman Hutton in New York. “They want to pare down at once,” he says, and computers make it happen.
IDS’ Anderson favors market circuit breakers, because they can slow down the process of a selloff. But he admits that the financial power of institutional investors is such that “if enough of them decide to get out the door at the same time, there’s nothing you can do, to be honest.”
Indeed, the circuit breakers may mean that instead of a one-day, 500-point Dow selloff, a 500-point decline would come in 100-point chunks over a five-day period, if enough money managers turned bearish. What isn’t clear is which of those two possibilities would unnerve investors more--the fast hit or the drawn-out decline.
The debate is certain to take center stage again now. On Wednesday, the Securities and Exchange Commission will take up the NYSE’s longstanding proposals for additional market circuit breakers. One proposal would make mandatory the NYSE’s now-voluntary limits on brokerages’ index arbitrage activities, whenever the Dow moves 50 points.
But the problem of huge market moves is probably not truly solvable, many experts agree, because of the size of the stock holdings that big money managers control. The NYSE’s blue-ribbon panel on market volatility, which released its long-awaited report on May 24, concluded that circuit breakers should be instituted and that other steps could be taken to reduce stock swings somewhat.
The panel’s basic conclusion, however, was that market volatility is something investors are going to have to live with.
“The stock market is not the same as it was in the 1950s, ‘60s or ‘70s,” Shearson’s Grennan says. “It’s an institutional market. We have gotten big, through no one’s fault.”
BLUE MONDAY How key stock indexes fared in Monday’s rout.
Monday Point Percent Index close loss loss NASD OTC composite 444.64 -10.63 -2.3% H&Q; tech-growth 684.28 -14.80 -2.1% Dow transports 1,136.13 -23.18 -2.0% Dow industrials 2,904.70 -56.44 -1.9% S&P; 500 355.31 -6.30 -1.7% NYSE composite 194.22 -3.43 -1.7% AMEX market value 354.92 -5.53 -1.5% Dow utilities 200.20 -1.95 -1.0%
HARD-HIT SOUTHLAND STOCKS High-tech companies were among the biggest losers in Monday’s stock market drop. A look at some Southland stocks that dropped sharply.
Monday Point Percent Stock close loss loss American Ecology $10 -1 3/4 -14.5% Micropolis 8 3/8 -1 1/4 -13.0% Tokos Medical 13 1/8 -1 5/8 -11.0% Marshall Industries 25 7/8 -2 -7.2% Kasler Corp. 12 1/4 - 7/8 -6.7% CalFed 13 7/8 -1 -6.7% Software Toolworks 16 -1 1/8 -6.6% Applied Magnetics 11 1/4 - 3/4 -6.3% Pinkerton 19 -1 1/4 -6.2% Litton 71 1/2 -3 -4.0% Disney 124 -4 1/2 -3.5%
