David R. Kotok, Cumberland Advisors

May 8, 2010

America’s stock market turmoil scared the “H” out of everybody this week. Part of it was a serious 8% (so far) correction which was long overdue. Markets do not go up or down in straight lines. This one has been in a strong uptrend since the March 9, 2009 bottom. The market’s correction started from an interim top on April 26.

In the midst of this correction we witnessed a 1000-point drop of the Dow. Most of it occurred in 15 minutes in the middle of Thursday afternoon. The subsequent 600-point 15 minute reversal only complicated investor’s perceptions. This bizarre market behavior leaves them quite unsure of the future.

American’s confidence in Wall Street was already low. It is now eroded even more than before. Thursday’s drama comes on the heels of the last three years of financial-system failure in the United States. It piles on the sequence of Countrywide and WAMU, Lehman, Fannie, Madoff, Goldman, etc. Ugh! What a blotch on American history!

In Thursday’s sell-off we saw transactions that made no sense. I personally witnessed the trading in an ETF that is composed of an equal-weighted basket of the 500 stocks in the S&P index. The symbol is RSP. It traded from 40 dollars a share down to 10 in a straight line. Of course that price was not due to any accurate valuation; it was an error. It was driven by electronic interfaces and did not involve humans. It was later rescinded. The New York Stock Exchange invoked a procedure called the “Clearly Erroneous Execution Rule.” It permits the exchange to cancel trades of this type. There is no appeal from their decision.

The NASDAQ canceled trades in 281 securities. 193 of them were ETFs, according to Matt Hougan of Index Universe. Matt is a recognized expert on ETFs.

Let me be clear. I do not want to single out Rydex and RSP. Nearly all ETF sponsors had canceled trades. For example: iShares, Wisdom Tree, SPDR, and Claymore were among the list of the 193. The key takeaway is that the arbitrage mechanism and creation unit system of the ETF process failed miserably for those investors who do not understand it.

This was a warning to ETF investors who use stops without thinking about them and who trade ETFs without comparing the price to an accurate estimate of the specific ETF’s net asset value. Simply put: if you do not know what you are doing, you are playing with fire and can get burned. Many did on Thursday.

David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com

Category: Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

4 Responses to “Thursday’s 15 minute crash; Kotok’s polemic”

  1. Abhishek says:

    Europe is involved in a different sort of blame game which is sort of funny. Read this

    Britain’s refusal to entertain eurozone curbs on highly speculative investment fund managers has cost Europe dearly, former Spanish prime minister Felipe Gonzalez said on Saturday.

    “Look at the hedge funds decision that was put off” in March, Gonzalez told reporters after unveiling a two-year, million-euro report into the European Union’s future 20 years down the line.

    “Because of elections,” specifically “the general election held the day before yesterday” across England, Scotland, Wales and Northern Ireland, “we have all seen more and more speculative attacks, which are going to continue apace,” he said in Spanish comments relayed through EU interpreters.

  2. deanscamaro says:

    Hmmmm!?!? Sounds exactly like the head of an investment advisory company……..you dirty, ring-necked commoners out there shouldn’t be investing on your own. You should be coming to us to pay the fee and let us advise you on what you should do. Look back at the last two years and this latest correction that happened. You were the cause of all that and if you were with us, this could all have been avoided. “Mumble, mumble……I don’t know why we have to deal with all these idiots out there.”

  3. CitizenWhy says:

    Since traders made a lot of money of the big dip, won’t they deliberately cause “accidental” dips in the future?

  4. cewing says:

    At this point in U.S. history, even moreso than the days of the bucket shops of the 1890s, people who aren’t brokers who have money to spend should avoid the U.S. stock market like the plague.

    If this stock market was based in Russia instead of on Wall Street, every American pundit would be pointing and laughing at the sucker who would be stupid enough to participate in this system that’s beyond rigged, that’s designed and built for a specific small class of monied elites to rake in all the rewards while everyone else takes all the risks.

    Most sane people wouldn’t participate in a poker game where one guy gets to deal all the time while also getting to look at everyone else’s cards before handing them out. But that’s what the U.S. stock market is, and probably always has been.