Getting from Price A to Price B has never been a smooth line in the stock market. It’s not going to get smoother any time soon.
You might say that Wednesday morning’s 435-point plunge in the Dow Jones industrial average in the opening minutes of trading was a slight overreaction to International Business Machines’ earnings report.
But the negative market sentiment of recent weeks pumped the news to excessive proportions in thin after-hours trading Tuesday and on international exchanges overnight.
When the New York Stock Exchange opened, the air came out of the tire.
Investors are in the process of reassessing stock values in light of several events that ended a fairly benign summer on Wall Street.
The run-up in oil prices, conflicting patterns of higher inflation and slower economic growth, currency imbalances, fading profit expansion, Mideast hostilities and political uncertainties in the presidential election–these trends and others find expression daily in the prices for stocks and bonds.
But none of these issues and events, separately or taken together, fully explain the manic-depressive behavior of the stock market. Part of the answer lies behind the scenes, in the fast-changing mechanics of the stock market.
Markets have worked well during recent volatility. A computer glitch at the Nasdaq stock market Monday delayed price and trade message traffic for about a half hour to various quotation vendors, without serious consequences.
Trading volume on Wednesday was the highest since April but well below records on the NYSE or Nasdaq. Nonetheless, the Option Price Reporting Authority, through which the five U.S. options exchanges relay price information, posted a record rate of message traffic–4,100 messages per second.
Edward Joyce, president of the Chicago Board Options Exchange, said all went well. The options industry has doubled its capacity to handle price and trade messages in recent weeks, he said.
But risks of mechanical breakdowns loom. Federal Reserve Board Chairman Alan Greenspan warned Monday at a conference sponsored by the Federal Reserve Bank of Atlanta: “Already, there are signs that trading volumes are straining the capacity of the [market] infrastructure. … Should capacity problems emerge because of a volatility-induced spike in trading volumes, the equity markets themselves could be compromised.”
Greenspan welcomes innovations in securities trading but recognizes that the path toward the fastest, fairest and safest system will be strewn with false starts and failures in what he calls the process of “creative destruction.”
Earlier this year, Securities and Exchange Commission Chairman Arthur Levitt said that in the current fragmented stock market, where numerous electronic trading systems compete with traditional exchanges, most investors do not receive the best available price when they buy and sell shares.
This handicap can be more costly than brokerage commissions, Levitt said, noting that few investors have any idea what happens to their orders to buy or sell.
On the other hand, many recent innovations in stock market trading appear to benefit individual investors more than institutional investors, said Ananth Madhavan, managing director of research for Investment Technology Group, which operates a major electronic stock order matching service, POSIT.
Madhavan told the Atlanta Fed conference that the rise of online trading has boosted market democracy for individual investors but, at the same time, magnified intraday market volatility and complicated the traditional role of institutional investors. Greater volatility erodes market liquidity, he said.
The ability of online investors to overreact to stock market news and to act on their naive overconfidence or regret is roiling markets as never before, he said. “These phenomena represent the dark side of the Internet revolution,” he said.
One result is a more easily manipulated stock market, Madhavan said. Another result is the diminished willingness of institutional investors to declare a variety of prices around the current market price at which they would bid to buy shares or offer to sell shares–a process known as market depth.
According to the CBOE’s Joyce, two challenges confront stock and stock options markets in the months ahead. The first is the SEC-ordered implementation of decimal pricing for stocks, replacing the historic system based on fractions of a dollar.
Decimal pricing will reduce greatly the price increments by which stocks and stock options trade, thereby vastly increasing the amount of trades and trade-related computer messages needed to get from Price A to Price B.
“The human eye cannot see the speed of the changes in prices,” Joyce said.
Second, markets need better and faster links to handle intermarket trading on highly volatile days, Joyce said.
Investors are plugging ever more bits of information, like electronic gadgets, into the Wall Street socket. They could blow a fuse.
