Program trading looks at prices, not investment fundamentals
Boston — The 508-point fall Monday in the stock market made history, Nick Whitridge says, because of uncontrolled selling. ``We're creating the buying opportunity of this half-century, because the decision to sell had nothing to do with investment fundamentals,'' says Mr. Whitridge, portfolio manager of the Babson Value Fund, Boston.
The decisions to sell - and later this week, to buy - are made when computerized program trading kicks in automatically, ordering a sale or purchase, when stock prices reach a predetermined level. Program trading, also called stock index arbitrage, looks at differences between stock prices and index-futures contracts and tries to find ways to make a profit.
Index-futures contracts, based on the Standard & Poor's stock index, require an investor to buy a contract based on that index by a future date. Investors use these contracts to hedge a portfolio, because of the liquidity they provide. The Chicago Mercantile Exchange trades the most popular futures index.
Program trading, done primarily by institutional investors, has been much maligned for its effect on the stock market. A closely-related technique known as portfolio insurance also has received attention, because it, too, tries to protect investors from market falls through sophisticated computer programs.
The New York Stock Exchange Tuesday asked brokerage houses to temporarily restrict this trading and walk the orders across the floor, to help keep the computer systems from bogging down.
On Monday the exchange's computers completed 600,000 transactions. Before the dramatic market activity of the past few weeks, the average number of daily transactions was 145,000, according to the Securities Industry Automation Corporation.
``Most money managers would have problems identifying the economic values of program trading,'' says Graham Tanaka, president of Tanaka Capital Management, New York.
The volatility raises the cost of capital. Investors demand a higher premium for higher volatility, Mr. Tanaka says. ``In times of extreme swings, there is the danger that the market's volatility could halt consumers' decisions.
``If you step away from the situation and ask yourself what the stock market is about, it's about financial growth and raising capital,'' Tanaka says. ``With program trading, people aren't asking about the fundamentals, but at what point program trading kicks in.''
Another criticism of program trading is the automatic mechanism. ``When you have things tied to futures and indexes, many stocks are bought and sold automatically,'' observes Mark Dollard, a senior vice-president at Amivest Capital Management, New York.
Program trading works off the spreads, or differences, between the stocks and futures. ``You're purely automatically executing orders, and increasing volume and volatility, without human judgment,'' Mr. Dollard says.
But program trading does have some defenders. ``It makes the markets more efficient, by making prices in two different markets basically the same,'' explains Marshall Blume, a professor of financial management at the Wharton School of the University of Pennsylvania.
``If the spot market is priced higher than futures, I can sell stock in the spot market and buy futures, lock in the gain, and hold that to maturity,'' he says.
Others defend program trading by saying that once stock prices have fallen, as a result of the trading, the lower prices become attractive and bring investors into the market. One broker says program trading is not the issue in the market; the federal budget deficit is. ``You don't shoot the messenger just because you don't like the message,'' he says.
In addition, program trading does not harm the long-term investor, Professor Blume says. ``The people who get hurt are the individual traders going in or out of the market quickly,'' he says. ``Individuals probably shouldn't be doing this.''
Program trading's exact role in the Dow Jones industrial average's record fall Monday and the record share volumes Monday and Tuesday, of 604.8 million and 608.1 million respectively, is hard to determine, for a couple of reasons.
First, market data was running up to two hours late, as computers strained to keep up with sell orders. ``The tape was lagging, and the computers couldn't calculate profits,'' Blume says.
Second, after last Friday's fall of 108 points, people were ready to sell. ``The closest comparison to make is that the market is people in a movie theater, and portfolio insurers are those who run first at the smell of smoke,'' says James Engle, a vice-president at Wood, Struthers & Winthrop, New York.
Portfolio insurers practice a technique closely connected with program trading. ``Investors determine their risk aversion to downside pressure and set their programs accordingly,'' says Jim Kalil, president of Compu-Val Investments Inc., Wilmington, Del.
When the market falls, earnings from selling futures offsets some stock loss. When the market heads up, climbing prices increase an investor's portfolio.
Yet, such insurance in a volatile market may create a downward spiral. ``When stocks sell, the values drop, and this can depress the stock market. This can trigger other insurance programs down the line,'' Mr. Kalil notes. ``Everyone sells stock and nobody buys. In theory, portfolio insurance looks great, but in practice it can be vicious.''