There is this incredible witch hunt by anyone and everyone looking for the cause of the 1,000 point drop the other day. As I previously wrote, I think it was just pure good old fashioned fear. Was it exacerbated by technology? Perhaps, but fear was still the main driver. There are times, unbelievably, where a market just simply has no buyers. That’s right. For whatever reason, negative news perhaps, fear, illiquid market, seeing people rioting in the capitol of a major European city, etc there just aren’t any bids. If you don’t have any (or many) bids and you have a swarm of sellers then the few bids on the board get hit at potentially low prices. This is exactly what happened last week. It has happened since well before there were any computers and it happens now that we have computers (though perhaps a bit faster). Just look at some intra-day charts from the Great Depression. Huge drops were not uncommon. I’ll share an experience I had once. It is not the best example, but I have seen, first hand, what happens when fear grips a market:
I was trading long a particular futures contract late one night and a very important overseas report was due to come out. I was in the trade for this event and nothing more. This was back in the middle of the financial crisis so markets were very jittery as they are now, but I had been more than thorough with my research and felt that I had an edge. If the news is bad I hit the bids and I am out. If it’s good I wait for someone to buy me out (hopefully) at an undeserving premium. The overnight futures market can be very illiquid – prime for capturing inefficiencies, but also a very scary place to trade.
The news hits. It is bad. Sh*t! The bids fall off the board. There are no buyers. No one for me to sell to. Bear in mind this is 3AM EST and no one in their right mind is trading or even paying attention aside from a few market junkies like myself. So what do I do? I put in a bid WAY below the last price. I’m testing the waters to see if there is a bull out there who will match my price and maybe test the higher prices for me. And who knows, maybe I become a buyer at a very low price. I’m sort of playing both sides of a very inefficient market – not unlike a market maker. What happens next? My workstation buzzes and my buy order goes off. Someone was panicked by the news and hit my bid! I relaxed for a bit to make sure that what had just happened had really happened. Yes, someone had hit my bid and effectively lowered my overall basis to a point where I would certainly break-even on what should have been a losing trade. I went to bed thinking I had just saved myself a handful of cash in a few minutes. It was an inefficient, illiquid and fear-filled market at its most raw.
What happened next was unbelievable to me. I wake up in the morning and my order is busted out. I literally don’t own the shares I had owned when I went to sleep just a few hours before. The guy/gal placed an order error with the exchange and they actually busted the trade out. I couldn’t believe it. I called the exchange and no reasonable response was provided. I wound up taking a decent haircut on the trade, but it isn’t the only time I’ve seen weird things happen in an illiquid market and it won’t be the last. It’s not a perfect example, but this is a real-life example of what can happen when a market is illiquid and the buyers just dry up. People make mistakes, make rash decisions and sometimes markets crumble to prices they should never be at in the first place. Fear is a boring excuse for a market crash, but it’s always the cause and it always will be. After all, psychology will always drive markets regardless of how many computers we have up and running. At some point, raw human emotion always plays into the equation and that is the primary reason why markets are inefficient and will always be so.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.