When algorithms take charge of markets, anything goes

Financial advisers should not only be strong strategists for their clients, but also equally passionate educators. There is no subject that gets me going more than market volatility in general, and in particular the potential dangers of high frequency trading, or HFT.Volatility is a part of the “new normal,” due to fundamental changes in market structure, and the more we understand it, the better we can assist the investing public.We need to go no further than the “flash crash” of 2010 as an example of how people in the financial world quickly forgot the metaphorical icebergs just averted.Do you remember? I have not forgotten the unsettling events of May 6, 2010, during which the Dow Jones Industrial Average dropped some 600 points in a few seconds. The market that day started out with media chatter that continues to sound Grecianly familiar.For a few minutes, starting at 2:45 p.m., prices entered an alternative universe that few could comprehend. One Dow Jones stalwart, Procter & Gamble, reached $100,000 a share while otherwise strong companies such as Boston Beer and Accenture saw their stock temporarily drop to a mere 1 cent per share.There was an equally fast recovery, but in my opinion, the damage to institutional credibility had already been done.Markets can move in either direction, to be sure, but dramatic swings should provide us with important lessons. The 2010 flash crash was one of the mileposts that reminded us that we live in a brave new world of market action and understanding.The events of that day, which could have been far more catastrophic, were not the results of a so-called rogue trader or an accidental push of a button, but something more systematic. It was a snapshot of what happens when the human side of order execution is superseded and overwhelmed by sophisticated computer algorithms.These algorithms might kick into action automatically on a wide range of fronts. In my opinion, computerized trading algorithms are designed to protect some positions and ruthlessly exploit others. Many times they are designed for quick buys, sells and profits. The profits or losses are made in nanoseconds when algorithms are involved.Psychological impactsIt’s easy for many to regard the 2010 flash crash as an anomaly but my 28 years of experience tells me that is not the case. Market structure has changed and markets are analogous to oceans with species that make up a complex and interdependent ecosystem. When one of those species, HFT, becomes 70 percent of the ecosystem, the imbalance can potentially undermine the overall health of the system.In a classical market structure, few would argue against increased liquidity, but the current environment is hardly ideal, because more liquidity than ever is based on HFT. One second the bid is good; but the next the bid is gone. In my opinion, the HFT tail could be wagging the stock market dog.For an economy and shareholders looking for liquidity to reward the shareholders and provide a semblance of capital liquidity for economic development, this is a sobering reality.To return to where I began — any market system can challenge the psyche of investors and, yes, their advisers. If we “enjoy” another flash crash or unsettled decade, the psychological impact on investors could be significant.Never before have we seen such a dichotomy between the forces in the market — some investing for the possibility of long-term returns (large institutional investors, 401(k) fund holders, and retail investors) and those in for a micro-second burst for a chance to gain a short-term profit.It is important to remember, the markets themselves are for-profit enterprises.When I began as a financial adviser almost three decades ago, the New York Stock Exchange had a specialist system whose job was to “provide a fair and orderly market.” Today, I believe, anything goes when algorithms have taken charge, and recent announcements by the Securities and Exchange Commission bear watching. As investors, understand who advocates on your behalf.Tom Sedoric, managing director-investments of the Sedoric Group of Wells Fargo Advisors in Portsmouth, can be reached at 603-430-8000.