Thursday, May 13, 2010

What really caused the stock market crash

Dan Ferris: What really caused the stock market crash
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Thursday, May 13, 2010
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By Dan Ferris in Extreme Value:

[E]veryone is wrong about what happened in the stock market last week...

I've seen various calls by journalists, hedge-fund managers, and others to ban "bots," computer software that automatically sells stocks when the market falls, similar to the portfolio-insurance programs that helped tank the market in October 1987. Bots or not, the idea that you should follow the market's momentum and sell what's falling certainly contributed to Thursday's rout.

But I'm loath to say, "There ought to be a law." The trouble isn't bots. It's the idea that you should let the market's action tell you what to do. It's as impossible to outlaw that idea as it is to outlaw human nature. There were no bots in 1929, and the market still jumped out of bed and hit the floor like it was late for work.

Outlawing bots wouldn't eliminate the certainty that markets will correct and rally and crash and soar, and there's not a damned thing anyone can do about it. You can't change it because you can't change human nature. Since there's no problem other than the persistence of stupid behavior, the lack of a pat-sounding solution leaves politicians without a soundbite to vomit up for the news media.

The only "solution" is the one you don't want to hear. In financial markets at least, human beings should be fully exposed to the risks inherent in their own flawed nature. It's impossible to expect people to become better investors if you protect them from their own foolish behavior. I'm not holding my breath, though. I realize the removal of paternalistic market regulations is off the table, since it would put a whole class of politicos and pseudo-intellectuals out of business...

Academics, lawyers, and other highly educated people tend to suffer from a fatal conceit. They believe deeply in their own ability to micromanage other people's lives. So they're constantly coming up with schemes like Social Security, Medicare, Medicaid, and compulsory health insurance. And they want to outlaw everything that reminds them of their own stupidity (i.e., their limits). When the market proves to them they aren't in charge of anything, they respond by calls for more regulation.

The situation is perpetuated by another quirk of human nature. Meddling society-designers don't acknowledge the often horrible unintended consequences of their actions. For example, Chicago's murder rate has soared since the gun ban, even as the murder rate in Washington D.C. has dropped in the wake of the Supreme Court's decision to strike down the city's handgun ownership ban.

The only reason for the persistence of failed ideas – like mandatory health insurance, financial market regulation, and gun control – is bad ideas feel good to pseudo-intellectual Ivy League graduates. As educated people who can speak and write effectively, they're able to convince thundering herds of lesser intellects to go along with bad ideas. That's why society-designers tend to thrive in places where ideas don't have to work to survive, like academia and government.

In reality, more guns coincide with less crime, all over the United States. In reality, mandating health insurance ruins the quality of medical care, all over the world. In reality, financial markets work best without meddling bureaucrats getting in the way of the price-discovery process (as they have in the sclerotic mortgage and housing markets).

If the society-designers in Congress banned the bots used to pursue momentum-trading strategies, I promise there'd be at least one enormous, bad unintended consequence. They'd deny responsibility for such consequences, as always. I also guarantee you they'd offer even more regulations to solve the new problem they created.

Bots didn't cause the market's decline last week. The decline proved the efficiency and power of markets, and represented the lack of problems in that part of our financial system, not the presence of any big problem, like you see being widely reported in the news.

The inconvenient truth is that human nature caused last week's decline. That's what irks the society-designing meddlers so much. That's why the voices were so many and so shrill to have Congress "do something." For once, I wish these people would just do nothing. If they all failed to show up for work for a year or two, we'd be much better off.

Crux Note: Dan says there's only one type of investment you never have to worry about, regardless of what the markets are doing. Dan calls these stocks "World Dominators," and he's releasing his latest pick tomorrow after the close. To get the details, click here.

More from Dan Ferris:

Dan Ferris: The only investment you never have to worry about

Must read: Dan Ferris on awful "Atlas Shrugged" developments

Dan Ferris: What no one else will tell you about Thursday's crash

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