Awaiting the Next Crash

"We've now dropped three or four hundred points here in the past few minutes," said CNBC anchor Erin Burnett.

It was May 6, 2010. We now call it the flash crash.

You can see why, as other CNBC anchors chimed in.

"Down 900 now! Holy .... I mean, wow. This is just ..."

"This is fear. This is capitulation."

"No. This is just impossible ..."

"If you are a retail investor, don't touch your TV. But also, don't touch your telephone and call your broker. Not a good thing to do."

That last bit, which came from CNBC anchor Rick Santelli, was the most prescient. As we now know, the flash crash was just that: a flash. A few computers making trades for hedge funds got confused and flamed out. It happens. Computers do this. As a PC user, it's a daily occurrence for me. The flash crash was over in a few minutes, regaining almost all lost ground as quickly as it evaporated. The Dow reclaimed its pre-crash level within a few days.

I've written before that the flash crash was a non-event. Most investors didn't hear about it until it was over and losses were recouped. It didn't affect them at all. Most seem to agree. The biggest pushback I've received came from a reader who had a stop-loss order triggered by the crash, causing an automatic sale of stocks at wildly depressed levels -- an unfortunate incident, but one that highlights the hazards of stop-loss orders more than flash crashes.

Others are still transfixed with the event. Take a recent Barron's article forewarning about a new risk: a splash crash. That is, "a dislocation by high-speed trading computers that could simultaneously splash across many more asset classes and markets."

The article goes on to quote the chief technology officer of a company that produces trading software: "I think there is an extreme risk of seeing this because we're not serious about putting measures in place to police against it," he said. Then came a rather amusing statement: "You almost need something like a Norad [the joint U.S.-Canadian North American Aerospace Defense Command]... for the markets."

When someone compares a minutes-long market hiccup to incoming nuclear warheads, rationality has officially gone AWOL.

I don't think we need any regulatory change policing against another flash crash. On the list of economic problems our country faces, flash crashes rank somewhere between "the bank put a hold on my paycheck" and "going to the DMV takes up an entire Saturday."

It all comes down to the definition of risk. Three kinds of risk pose a legitimate threat to investors. The first is valuation risk, where investors pay too much for good companies. The second is business risk, where companies suffer a misstep that lowers their intrinsic value. The third is leverage.

Flash crashes cause none of these.

They can actually cause the opposite: opportunities to purchase good companies at bargain prices. A market crash caused by a computer glitch that has no impact on a company's intrinsic value is a public service. Rational investors should beg for them. In this sense, it's odd that policymakers view flash crashes with such trepidation, yet have a long history of cheering loudly for market bubbles that wreak havoc on household finances. Ideally, regulators would welcome opportunities for mom-and-pop investors to exploit computer-driven hedge funds that occasionally go haywire, and warn noisily about the dangers of bubbles.

The fact is that flash crashes caused by high-frequency computer traders harm just one group of investors: those who need to buy or sell stocks now. Thankfully, this describes only one group: high-frequency computer traders.

All you need to remember are two things. The first is that last year's flash crash lasted only a few minutes. The second is a famous Warren Buffett quote that's guided Berkshire Hathaway's (NYSE: BRK-B  ) success over the years: "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."

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Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (19)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 24, 2011, at 6:57 PM, drborst wrote:

    Morgan,

    Nice perspective, it was a "non-event" for most.

    But the flash crash made me think about what I suspect is true: that every time I use my computer to tell my broker's computer to ask the computers on wall street (or are they in New Jersey now?) to buy or sell a stock, some hedge fund computers jump in and trade a few times and cost me a few pennies.

    That feels like a tax on the trade, only the money goes to rich people who can afford the computer and the clever programmer to make it work. I can tolerate paying taxes to a representative government, but paying them to some rich people fills me with disgust. I realize those few pennies are probably less than the ~$10 I pay to my broker for use of his computer in the transaction, but the disgust I feel, the sense that the market is somehow rigged against me... if others get the same feeling, that can't be good for the market.

    DRB

  • Report this Comment On May 24, 2011, at 8:33 PM, DocG1956 wrote:

    You compare the flash crash to a stop loss.

    That should have fully disqualified you from representing what this site stands for. So sad.

  • Report this Comment On May 24, 2011, at 10:52 PM, TMFHousel wrote:

    Docg,

    I think you misread that section. It isn't comparing a stop loss to a flash crash. A reader had a stop loss that was triggered by the flash crash, so his/her portfolio was dinged by the event. Otherwise, the flash crash harmed very few investors.

    -Morgan

  • Report this Comment On May 27, 2011, at 12:53 AM, daveandrae wrote:

    The psychological effects of the 2007-2009 bear market cannot be overstated. For the vast majority of people I know are so well positioned for a crash, and proud of it, that they missed the entire run from 666 to what is now 1330. The same people I told to get out of cash at Dow 8,000 are STILL in cash at Dow 12,400.

    Never in my life have I talked to so many people that were perfectly content to be fully invested in an asset that yields 0% when the s&p 500 was trading at less than 13 times forward earnings.

  • Report this Comment On May 27, 2011, at 2:03 AM, TomBooker wrote:

    The flash crash harmed very few investors because they fixed "broken" trades.

    The SEC print blamed it on a boutique trader unloading a big position for his Fund.

    90 minutes later, the CBOE went print with the step-by-step of the transactions. Their evidence determined that it was the digital or carbon units taking the position from the Fund, that brought on the crash.

    As the SEC claims everything under control, the Exchanges and they will no longer fix broken trades, because they don't exist. How's that for metaphysics. ;)

    One of my favs to-someday-be-disruptively-great with their motto of "Digital is Good", INFN was chosen as one of the ramp providers for The Spread Network. (no money in it, but it's a nice-to-have.)

    TSN latency to ping Chicago and back to NYC... 15 ms. In ideal conditions... 13.3 ms.

    It's not X-Files, but it could be fun some day.

    Biblical-like, "in the blink of an eye". ;)

    ***

    "In this sense, it's odd that policymakers view flash crashes with such trepidation, yet have a long history of cheering loudly for market bubbles that wreak havoc on household finances. Ideally, regulators would welcome opportunities for mom-and-pop investors to exploit computer-driven hedge funds that occasionally go haywire, and warn noisily about the dangers of bubbles."

    "odd" ? that's a masterpiece of moderation.

    C'mon Mr Housel. Say it... Say it outloud.... You know you want to do it.... You'll feel better after you do... We know why Bernie Madoff got nailed to the jailhouse wall, and the other guys will be spending their Memorial Day Weekend at their houses in the Hamptons Say it!. Say it!

    (Hear a Sam Kinison "AHHHH... AHHHHHHH" ;)

    ***

    Best to ya. You're one of the hopes for an honest and just country someday. ;)

    Booker

  • Report this Comment On May 27, 2011, at 8:09 AM, ServusDei7 wrote:

    I wish I had some limit orders at ridiculously low prices during the flash crash. I could have, for example, bought Accenture at 1 penny per share and would be so rich right now. Well too bad. Life goes on.

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