Over the past few weeks stock markets have been very volatile. With the election of President Trump and continuing until the signing of tax reform, it seemed like the only direction that stock markets knew was up. Then, thousand point drops, large volumes and apparent instability. What is going on?
In economics, we teach that markets are places that process information and that market-determined prices reflect that information. Changes in information lead to changes in demand and/or supply and then, as the market seeks equilibrium, prices change. Another way to think of this is to consider that every market participant, whether buyer or seller, is pursuing their own unique interests using the information that they think matters most. More importantly, not everyone in the market uses or has the same set of information. In fact, it is safe to assume that everyone in a market has different sets of information that drive their actions. So, in a sense, the market knows everything while no one person in the market knows everything. In the end, market prices reflect all the information that is known.
For quite a long time, the financial market price generating process involved actual human beings interacting with other human beings. With a group of MBA students, I was privileged to watch the public outcry auction process where gasoline futures were priced. (This place no longer exists.) Here, buyers and sellers circled a pit hollering bids and asks at each other. Once a cry to sell was accepted by a cry to buy the traders would go over to another area of the arena and record the transaction on a paper card. This card was then tossed into the middle of the pit where another human caught it and formally recorded the trade. In the meantime, the traders would go back at it.
This trading was really fun to watch. Successful traders were risk loving, animated, emotional people. In the pit, circled by very large televisions loudly broadcasting business and news channels, there was plenty of screaming and flailing of arms. Few, if any, of these folks had more than a high school education. The price-making that occurred in the pit was done in a crazy and emotional pit that only humans could create. I met a trader who wore Depends because he did not want to go to the bathroom and miss a profitable transaction during the trading day that did not stop for lunch!
Yet not that long ago, smart people at Lehman Brothers, Goldman Sachs and other houses figured out a way to do away with the humans. Now programmed computers trade. See, human-based transactions took time. Time was money. More money could be made the faster that trades could occur and be recorded.
Fundamental to this was someone, or a group of people, had to write the algorithms that drove the actions of the computers. Memory banks now contain commands when to sell and when to buy based largely on price changes? However, when some machines start to sell, other machines see this and start to sell too. Prices drop which, within the algorithms, cause more selling. Prices fall even more. When prices drop enough a new equation kicks in and says buy. Price recovers which causes more computers to buy and prices raise rapidly. Thus, the swings we have observed recently are probably the result of over exuberant trading by computers and not new information of impending doom.
Price fluctuations have always been part of the landscape of financial markets. Yet, back in the day, if the volatility of the market became too great the humans could talk to each and simply stop trading and try to figure out where all the craziness was coming from. Emotional humans could stop the process by simply being human. By removing the emotion we have removed, what some think, is stabilizing information. We may have reached the point where we have to decide if we want fast trades or human trades. I love the crazy pit of public outcry exchange. The pit was great. I vote for the humans. Break out the Depends!
Dr. Skip Mounts is the Dean of the School of Business and Public Management at the College of Coastal Georgia. Dr. Mounts is also a professor of economics and an associate of the Reg Murphy Center for Economic and Policy Studies.
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