More Interconnectedness, More Volatility

Mark Cuban, entrepreneur and the owner of the Dallas Mavericks professional basketball team, recently complained that the Wall Street game had changed. It's not enough any more to do fundamental research on individual companies, he said. Individual investors today have got to be a global macro hedge fund. It's too complicated, Cuban says.

There are changes. Last Thursday's "flash crash" -- when the Dow Jones Industrial Average lost 1,000 points in a few minutes -- was the latest evidence of the "new normal" the stock market is operating under these days. There's no question that volatility has increased sharply compared with, say, 10 years ago.

When events like last Thursday or the near collapse of the credit markets in September 2008 take place, government officials or market commentators have a knee-jerk first instinct to blame a discrete market actor like a rogue trader or rogue hedge fund. They blamed the hedge fund Long-Term Capital Management for sparking the Asian currency crisis of 10 years ago. They said it was a "fat finger" on some Citigroup(C) trading desk which caused last week's mayhem. On Tuesday, the Wall Street Journal ran a story laying the blame of last week on one trade by one hedge fund who pays Nicholas Taleb, the market watcher and proponent of "black swan" events in markets, as an adviser.

The trouble with these single actor or "it-was-out-of-our-hands" explanations for these crashes is that it suggests no major changes need to occur. As long as we prosecute the bad apples or make a tweak here or there to the existing system, we can continue on our way.

But, I've got news for you. Cuban is right that something systemic has changed on Wall Street, in our economy, and in our society. These changes have introduced greater interconnectedness, greater speed, and greater complexity to our markets and decision systems than we've ever had before.

These changes are mostly good and beneficial to the markets, but they do introduce much greater risk and volatility than we've ever seen before. At the same time, the system and rules by which the markets operate haven't changed. What this means is that it is highly likely that we will see large market swings again -- both intraday and over a period of many months. In fact, if anything, volatility is likely to increase in the years ahead, not decrease.