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What ETF Investors Can Learn from the May 6 Flash Stock Market Crash

Stock-Markets / Financial Crash May 13, 2010 - 08:15 AM GMT

By: Ron_Rowland

Stock-Markets Best Financial Markets Analysis ArticleIf you had any doubt that today’s markets aren’t what they used to be, it should be gone after last Thursday.

U.S. stocks were already having a bad day thanks to riots in Greece, elections in the U.K., freezing credit markets in Europe and a growing oil spill in the Gulf of Mexico. Within a matter of minutes that afternoon, even some blue-chip stocks went from bad to worse to catastrophic. Then, just as quickly, they came back!


What in the world happened? And what does it mean for you as an exchange traded fund (ETF) investor? Today I’ll try to give you some answers …

ETFs Caught in the Storm

Last week the markets hit rough weather.
Last week the markets hit rough weather.

One of the attractions of ETFs is that they are exchange-traded, which means they can be bought and sold all day long, just like stocks. Last Thursday, however, that feature proved itself to be a risk factor as well.

When circuit breakers brought NYSE trading in some key stocks to a halt, their prices plunged on various electronic systems. And ETFs that held those stocks dropped as well.

The “market makers” who are supposed to provide liquidity — didn’t. And the fear quickly spread to all corners of the equity markets. Stocks and ETFs traded — and some orders were filled — at discounts of 50 percent or even 90 percent to where they had been just minutes earlier!

For instance, the iShares Russell 1000 Growth (IWF) is a popular ETF that typically trades more than three million shares a day …

Last Thursday at 2:40 pm Eastern time, it was trading at $49.70, which at the moment like most of the market was down about 3 percent. Over the next five minutes it fell to $48.29, another 3 percent drop. A minute later, at 2:46, it was at $44.23.

Then the bottom dropped out …

At 2:47 IWF traded at $19.98. Prices continued to plunge during the next 30 seconds. Many trades went through at 15 cents and one at a penny!

When the minute was up, IWF was again trading at $47.43. A minute later it was back to 10 cents. Stability returned as it climbed from $17.69 to $36.88 to $49.65. By 3:00 IWF was back above $49, completing its round trip in about 16 minutes.

(Note: Trades below $19.88 were cancelled for IWF. But thousands of shares traded at a 40 percent to 60 percent discount to prices prevailing just minutes earlier.)

Politicians wasted no time jumping on the bully pulpit.
Politicians wasted no time jumping on the bully pulpit.

If your reaction is “this makes no sense,” join the club. Indeed it doesn’t make sense — but it happened.

One thing we can always rely on, however, is a swift and senseless reaction from Washington …

Even before the dust settled, people on Capitol Hill were shoving each other out of the way to get their share of the headlines. Regulators sniffed and threatened investigations.

I’m totally in favor of appropriate market safeguards. But I’m against overreaction that makes the problem even worse — and I fear that’s what we are going to get.

News Flash: Markets Go Both Ways

Here is a hard truth the politicians and regulators don’t want to admit: Markets are volatile. They go up, they go down. Everyone has an even chance to profit if the playing field is level.

Look at what just happened last week …

Somebody bought all those stocks and ETFs that traded at such ridiculously low prices. They were smart to do so. They deserve to profit — but they aren’t going to. Why? Because the exchanges decided to cancel many of the “outlier” trades.

Call it whatever you want, but this does not make for a free market. Instead it’s a market in which people who make bad decisions try to pass the buck to someone else.

In today's fast moving markets, meltdowns can occur.
In today’s fast moving markets, meltdowns can occur.

The best policy is usually to let prices find equilibrium on their own. This is the only way to discover the bottom. A stock (or a house or any other asset) is worth as much as someone is willing to pay for it — no more, no less. Discovering this level is why we have markets.

The knee-jerk reaction, though, when prices are falling is to stop trading. But attempts to interfere almost always backfire.

In last Thursday’s meltdown, the NYSE tried to call a brief time-out because stocks were falling. The computers refused to cooperate.

The government is probably going to respond by muzzling the computers. If they do it, it’ll be a big mistake — and we’ll all pay for it in the next crisis.

Think about it for a minute. Computers can be reprogrammed, and they will be reprogrammed to do whatever their owners think will maximize profit and minimize risk.

So the next time prices fall, for whatever reason, the computerized buyers-of-last-resort may not be there. They’ll stand aside and wait for better opportunities. And that could take a long time.

What does it mean for you? I still see many opportunities in ETF trading, so there’s no need to head for the hills. You do need to pay attention though, and learn two lessons from May 6:

Lesson 1 —

Try to always use a limit order and avoid market orders.

Lesson 2 —

Think long and hard before placing stop-loss orders on ETFs. And if you do, be sure to update them as your holdings rise in price. Otherwise you might end up selling for a whole lot less than you planned.

One way to avoid this is by using a “mental” stop-loss instead of an actual stop-loss order. With a “mental” stop-loss, your computer or broker can alert you if the price is breached and then you can place a limit order.

As always, stay informed and know what you’re doing before you buy.

Best wishes,

Ron

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.


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