Why Traders Get Trapped in a Panic

[We wrote here recently that last week’s panic attack on Wall Street is unlikely to be the last.  The markets have since rallied strongly, but that won’t change the outlook, says a wise friend of ours who has been following the markets for thirty years. In the essay below, he explains why shouting “Fire!” on Wall Street is not quite the same as shouting “Fire!” in a crowded theater. RA]

“Many years ago, while reading John Kenneth Galbraith in “The Speculative Episode,” it dawned on me that the world wasn’t necessarily becoming a safer place, particularly on Broad and Wall. If you think about military history, we’ve gone from flintlocks during the Revolutionary War with a range of 40 feet to the Spencer Repeating Carbine at Pickett’s Charge in the Civil War (every Confederate soldier died), to Hiroshima. On Wall Street, we went from the ticker tape running three hours late on 16 million shares in 1929 to program trading in 1987 when we didn’t have the Internet and you had to call your broker to know what was happening that day in the market.

Engraving of the panic of 1879

“Today, everyone has a quote in the corner of their screen at work or they watch CNBC at home. They are responsible for allocating their 401K online and many trade the rest of their nest eggs there too. The data processing capabilities out there can handle tens of billions of sell orders in a single day and on top of that, we have the CBOE and the E-Mini. Algorithmic Trading programs do umpteen trades a millisecond and make up 70% of the volume, one HAL versus another.

Technology Produces No Buyers

“The biggest problem, getting back to Galbraith, is that in the process of facilitating sellers, all the new technology does not produce any buyers. I know most will disagree with that, but keep in mind that demand is a state of mind. It runs away at the first sign of trouble. Put another way, the same emotions that motivate sellers cause potential buyers to hold off. Sell is preordained, but buying requires a complex greed analysis.  Which leads me to my “glass theater analogy.” We are all familiar with the most common analogy for panic:  when someone yells “Fire!” in a crowded theater. The problem, of course, is that there are 50 rows of seats, but just two aisles leading back to two doors on the back wall. Grown men and women may trample small children to escape getting fried.

“There are a couple of problems extending that analogy to the stock market, so I made some changes in my “glass theater analogy”. The biggest problem in the market is that, even if you choose the aisle seat, last row, you can’t escape unless you can find someone to take your seat. As Galbraith pointed out so many years ago, you can’t be a seller unless someone else will buy. (What a dirty little secret!). Another big problem, considering the speed of the technology today, is the basic transparency. It’s as though the back wall of the theater were made of glass, and all the potential patrons can see what’s happening inside. It’s right there on their screen! Who is going to take your seat when they can see the carnage going on in there? Which leads me back to last week’s mysterious plunge. First of all, remember that reading Alan Abelson the Saturday before the 1987 Crash, he indicated we had already had it with the 230-point drop the week before. The newspapers last weekend sounded a bit like a post mortem too. “The SEC is trying to get to the bottom of it.” I can save them the trouble. What do you expect when your weapon has a seven cartridge magazine in the butt compared to a single load, wad and ball. You get 1000 points in 15 minutes. Wait until the human nature kicks in again someday, in a big way. It might become 5000 points. You could retrace this bear market rally in a hurry.

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  • FranSix May 16, 2010, 3:54 pm

    Very unusual to have a market where the sellers had been taking a haircut for so long with a perpetual state of low volume buying, then suddenly turn them all into sellers in one go in one huge short sale.

    A successful short sale of this magnitude would have netted untold billions and shaken market confidence, but the rebound was so sharp, the end result would have been missed. A sell off was due, so taking advantage of hft in this fashion is not always a sure gamble.

    What’s even more unusual is the dip in the discount rate some 30% that day and its subsequent rebound the next of 20%. Rates are so low now that they’ll hit zero or go negative in very short order. A negative interest rate can have an adverse effect on valuations of just about everything.

    http://stockcharts.com/h-sc/ui?s=$IRX&p=W&b=5&g=0&id=p66874059515&a=191210523&listNum=2&listNum=2

  • John May 15, 2010, 9:06 pm

    My father was a penny mining stock speculator in the 1920’s thru 1960’s. He made lots of $$. He was often asked what caused the crash in 1929 and worse in 1932. His answer:”There were no bids.” Why confuse the issue?

    Rick is right on and a 5,000 point collapse is not an exaggeration.

  • JeffM May 15, 2010, 7:09 pm

    Great Article Rick.

  • Antonius May 14, 2010, 8:16 pm

    Benjamin: There have always been things to speculate on, like tulips in the 1600s. For more recent history in the United States, you should read about the Panic of 1873 and the Panic of 1893, both caused by rampant speculation in railroads. Both of these recessions were very severe (and violent, with large railroad and coal mining strikes). In fact, the Panic of 1873 lasted longer than the Great Depression!

  • Oliver May 14, 2010, 5:55 pm

    Silver 19,70 Euro bullion Philharmoniker. I bought at 17,70… Wednesday morning.

    Germans with positive bank accounts are leaving the Euro with their feet, now. My guess.
    I doubt gold and silber weaknesses for awhile now.

    Bullion stores in munich are empty shelves. If you´re a pensioner, you must feel like you got into a heist. Somewhere between 20 – 15 yrs of lower income, because of permant crises and reunification, and now an debt inflation for greek hairdressers?
    I don´t think politicians have understood, yet, what they are expecting from people, here…

  • Rich May 14, 2010, 5:54 pm

    Bugs, orphans and widows in gold here now?

    http://www.cnbc.com/id/15840232/?video=1494114810&play=1 4:14

    • John May 15, 2010, 9:01 pm

      There’s moderation needed in every situation. So “Yes”, if you have assets some of it should be in gold and silver. Of course if you know you will die tomorrow then blow the bundle!

  • fallingman May 14, 2010, 5:15 pm

    We humans process best via analogy and this fella has come up with a very apt one…a theater with a glass window where you can’t flee until you find some chump to take your seat…and s/he can see the conflagration inside the theater and is uh…dissuaded…from making a bid for the death seat. YES! Excellent.

    Thanks.

  • Chuck Griffiths May 14, 2010, 4:51 pm

    Benjamin- There is a time for love and there is a time for war. There is a time for gold and there is a time for stocks. Now is the time for gold. When everyone agrees with that, it will be the time for stocks.

  • Oliver May 14, 2010, 11:57 am

    Cool. Refreshingly honest account!

    Dr. Merkel, someone not so refreshing, isn´t off to the weekend, yet.

    Her polls tumble like silver (gold) rises.
    Trichet wants more German leaderhip? Why?
    You don´t need a leader to find out you owe too much 🙂

  • Benjamin May 14, 2010, 8:03 am

    “On Wall Street, we went from the ticker tape running three hours late on 16 million shares in 1929 to program trading in 1987 when we didn’t have the Internet and you had to call your broker to know what was happening that day in the market.”

    It’s definitetly a sign of my inexperience that I can say that even the latter was before my time. When I started trading it was as simple as creating a forex account online, email some documentation, and… start trading!

    And though I felt I did enough homework, I was still so nervous… even when I was making money. In fact, it was making money that made it all a rollercoaster of emotion. I used to think at those nervous, ecstatic moments that maybe I would rather lose money than make it. One can do their homework, yes, but nothing except the experience of making lots of money can prepare you for… making lots of money! It’s a burden, one that increases exponetially the greater the amount and the shorter time in which it’s made. I considered letting someone else manage my money for me, but then I discovered that doesn’t make things better at all.
    Nope, it’s an even heavier burden. So I parked it all in gold, silver, and cash. While it does on occaison keep me up at night, it still seems the wiser move.

    Anyway, yes, I can see how millions of people these days, either with easy access to a trading platform or money managers, can make this “glass theater” possible.
    And if one were to ask me, limited as my experience in these matters are, retirement nest eggs are meant to be kept IN. On one hand, you have taxes and other penalties. On the other hand, you have to wonder if you’ve saved enough. On another hand, there’s debt. Throw into that unhealthy mix that the job market has been as turbulent, and will get more turbulent yet, and you have all the components you need for an uncertain, fear-driven market, one which social security has no choice but to step in and try to make work (even though it only contributes to, if not drives the whole process!).

    In a word: ugly. However, at one time (if I understand the past correctly) there wasn’t really anything to speculate. Markets were flat-ish and wealth flowed just as easily as it saved. Recessions were shorter lived and not as pronounced as they are today. Unemployment wasn’t a word in the English language.

    I can’t blame the technology. As I said very briefly the other day, I think it’s the soundness of principle that matters most. Would all the ‘bots and other trading software have much to do if there was little to no room for rampant speculation? I think, in the absence of the ill-founded principles that allow that, computing power would be put to better use. Heck, we might even discover that we’ve an excess of it. Of course, I’m sure there are those in the world who don’t want us to think that. Again, the fear and instability. Who would want to face that kind of devaluation in this day and age?

    But that’s the serpent swallowing its own tail.Something will have to give at some point. It just has to. Creating more snake when the snake is already gagging in the pursuit of its own tail can do nothing to alleviate the problems.

  • ricpent May 14, 2010, 7:49 am

    Community service?

  • JohnJay May 14, 2010, 6:02 am

    So the SEC is finally going to consider criminal charges against GS/JPM/C/UBS/MS and DB. Either the IT guy at the SEC got around to blocking the porn websites, or this is more Kabuki theatre for the November elctions.
    Something seems to have motivated them to at least go through the motions of enforcing the law. I think RICO gets you 20 years for each racketeering count and treble damages in civil court, and forfeiture of all ill gotten gains. Or a $25,000 fine. See if you can guess which penalty they all get!

  • Oliver May 14, 2010, 3:00 am

    And thank god there´s resilient shorters like me ( Ok, I exchange every penny I make into something tangible since 2007), who will be the first buyers again.

    Otherwise it would be zero, nill, denada for noone knows how long in a crash.
    Why is this for politicians so stubbornly hard to understand?

    Noone teaches simple markets in school. From childhood on.
    You learn only myths there.