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Nejat Seyhun
  Nejat Seyhun
 

Panic on Wall Street

5/27/2010 --

Finance professor Nejat Seyhun examines triggers leading up to the May 6 crash in the Dow Jones Industrial Average and predicts investors may benefit from this unprecedented event.

ANN ARBOR, Mich. — An amazing event took place on May 6, 2010. Between 2:40 p.m. and 3 p.m., the Dow Jones Industrial Average dropped by a massive 1,010 points (more than 9 percent) from its intraday high. The size and speed of the drop was unprecedented, and this represented the largest point drop in Dow Jones history. What caused this sudden and massive crash in stock prices? What makes the stock market vulnerable to these panic attacks? What are the implications for the market? What are the implications going forward for the investor?

There have been three possible explanations as to the possible causes of the crash: market panic, trading errors (the so-called fat finger), and market manipulation. While it is too early to tell, initial investigations have not revealed any evidence of either manipulation or trading errors. During her recent testimony before Congress, SEC Chairwoman Mary Schapiro said there was no smoking gun pointing to a single cause of the crash. No one single trade can be identified as the leading cause of the crash. Similarly, no single institution was a massive seller. Instead, evidence suggests an old-fashioned panic.

Similar to previous panics, there was a growing investor concern leading up to the crash. This time investors’ concerns were focused on the nearly-bankrupt European sovereigns. Greece is mired in massive budget deficits, run-away debt problems, and growing social unrest. Default looks increasingly a likely outcome for Greece. Italy has similar debt levels as Greece, while budget deficit in the U.K. is similar to that in Greece. Portugal, Ireland, and Spain are not much better. Decades of welfare policies and runaway public deficit spending have given these countries large and unsustainable amounts of public debt as well. Meanwhile, taxpayers in Germany and France are balking at subsidizing the lifestyles of their profligate neighbors. These investor concerns and potential contagion effects to the U.S. markets were evidenced by a 270-point drop in the Dow over the previous two sessions.

A typical panic is preceded by what appears as a downward trend in stock prices and concerns about some fundamental factors. If sufficiently many investors believe that there might be a downward trend in stock prices, then in an efficient market, everyone will want to sell and no one will want to buy. In an efficient market such as the U.S., you cannot have trends in prices. If most people suddenly think the prices will fall, then prices must fall immediately, thereby destroying the trend. This sudden realization is pretty much what happened in the afternoon of May 6. Continually dropping stock prices served as a coordinating device, leading most institutional investors to start selling, or at least stop buying. Lack of liquidity meant that the bottom dropped out of the market with lighting speed.

The thousand-point crash itself cured investors' expectations of further stock price drops, thereby bringing back liquidity. By May 10 the European Union had decided to "solve" debt problems by borrowing more money, by putting together a trillion-dollar bailout plan to support struggling Greece and other European sovereigns. Short-term expectations reversed and investors breathed a sigh of relief, at least for a short while, until sufficiently many people realize some day in the future that you cannot get out of debt by borrowing more money.

While it is still early to fully sort out this crash, it is tempting to speculate about the implications. First, panic on Wall Street served as a poignant reminder to all regulators and policymakers the fragility of the global economic recovery. I expect Bernanke and Co. will learn the appropriate lesson from May 6 and postpone any monetary tightening until well after the economic recovery has solidified. In fact, these expectations of lowered rate increases were immediately reflected in fed funds futures prices. The probability that the Federal Reserve would tighten the overnight fed funds rate from 0.25 percent to 0.50 percent during its June meeting declined from 10 percent to 5 percent as a result of the May 6 crash. This is good news for the investor.

Another implication of May 6 is on the regulatory front. I expect Congress will be less aggressive in taxing the banking sector or in meddling in micromanagement of banks' activities. Already, the amendment to audit the Federal Reserve by Sen. Bernie Sanders, I-Vt., with potentially populist implications has been watered down. Expect additional good news on the banking sector. So, when all is said and done, a thousand-point decline in the Dow actually may be good for the investor.

Nejat Seyhun is the Jerome B. & Eilene M. York Professor of Business Administration and a professor of finance at Ross. His backdating work with Ross colleague M.P. Narayanan helped uncover one of the biggest corporate scandals of recent years.



For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, bernied@umich.edu