Friday, May 7, 2010

The Crash of 2.45 and Strategic Performance

By Dr. Suhaib Riaz.

The largest ever intra-day drop of the Dow (DJIA) has a name, "the crash of 2.45", referring to the time on May 6th 2010 when markets plunged, but has no explanation. The market players, the stock exchanges, the regulators or researchers seem to have no idea what really happened. There are two streams of thoughts developing: either the crash was an error or just a reflection of true market sentiment in the wake of the Greek debt crisis. The error theory seems to be gaining more ground, but this begs the bigger question: what kind of system allows for such an error that can wipe off $1000 billion in 20 minutes?

Stock trading exchanges are considered the heart of current free market systems. Stock markets are supposed to reward firms that do well, and in the process spur competition that adds up to a well functioning free market system. However, do stock markets today truly understand firm performance, or more specifically, firm strategic performance?

Managing for stock market value came in for much criticism from one thought to be a core proponent when Jack Welch called it "the dumbest idea in the world" in the midst of the current financial crisis in April 2009. Henry Mintzberg has been pointing to the problem for years, as summarized in his provocatively titled "How productivity killed American enterprise" (.pdf). The problem of increasing focus on short-term time horizons in capital allocation, particularly in the American institutional system, has also been pointed out (.pdf) by none other than Michael Porter. When Mintzberg and Porter agree on a point (which they don't always: Mintzberg's 'strategy as synthesis' versus Porter's 'strategy as analysis' being a major case in point), perhaps we need to pay more attention.

One could argue that what happened on May 6th at 2:45pm was an anomaly that was soon corrected to some extent by the market. However, such wild events can sometimes point to larger problems in the system. Earlier, the focus was on problems of meeting quarterly expectations, which lead to non-strategic performance evaluations, made worse by highly dispersed ownership in a market with institutional investors as major players. However, a gradual but phenomenal change has been underway through the introduction of computing power. Just as computing power has revolutionized developments in other fields, including famously, the race to discover the human genetic code, there has been a substantial increase in the frequency of trading, supported by computing power. In fact, the Financial Times reports that "algo-trading" is now the norm rather than the exception: "According to Tabb Group, a consultancy, algorithmic and high-frequency trading accounts for more than 60 per cent of activity in US equity markets." To understand the speed we are talking about, imagine that matches between buy and sell orders are found a 1000 times faster than the human eye can blink. What's strategic about performance within that fraction of time? Also, what's strategic about investment decisions made through algorithms that work solely on quantitative information, without understanding its context?

The regulatory bodies will move in on this for sure, but the answers are not simple. A slowdown in trades enforced by the stock exchanges already had unexpected outcomes, as would the cancellation of trades executed around 2.45pm. That wouldn't be a free market then, would it? Perhaps while grappling with these technicalities in the evolution of stock markets, the bigger question needs to be asked: Since the strategic performance of companies is the crucial parameter on which free markets should allocate capital, what kind of stock markets (and supporting institutional systems) would truly reflect strategic performance?

1 comment:

Anonymous said...

Well written piece.

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