McManus Talks Back on Circuit Breakers

By Tom McManus ,

(Editor's note: Last week columnist David DeRosa endorsed the newly proposed New York Stock Exchange circuit breakers. Occasional contributor Tom McManus, a veteran Wall Street strategist, says the new proposal misses the mark. He thinks the new rules are too loose. What do you think? Let us know.)

So you're tired of fumbling around in a dark cellar to find the fuse box every time you try to toast a bagel while your wife is blow-drying her hair? Go ahead, replace that 15 amp fuse with one rated at 25 amps -- or 35 amps, if at first you don't succeed. Just don't ask me over for coffee. What's more, I hope my insurance company hasn't sold your policy, too, because you're just begging for trouble.

Look, I was one of the first to point out 10 years ago that the circuit breakers would eventually have to be revised, because they were based on point moves in the

Dow

, moves which would become more commonplace as the market reached higher levels. Ten years later, with the Dow more than three times the level it was at when the circuit breakers were first set, the

New York Stock Exchange

experienced its first trading halts because of them. Trading on the venerable exchange was first stopped for a half-hour, and then later for the balance of the day, because point-sized trading limits -- originally intended to represent roughly 15% and 25% moves, but now only being 5% and 7% -- were tripped.

Think of it. It took 10 years to trigger these limits the first time, but they had to come into play eventually, because as the market appreciated, these breakers grew teeth. And do you know what? They did exactly what they were designed to do. Order was restored, and the market rebounded. But now, worried that they may be missing some precious trading volume, the Big Board is backing a plan to yank out every one of those teeth it took 10 years to grow.

The new circuit breakers will be updated quarterly to adjust for the market level, and it will require a 10% decline in the Dow before trading is temporarily halted. If the Dow is down 20% or more after 2 p.m. the market will close for the day. Before 2 p.m., it'll take a 30% drop in the Dow to get that closing gong to chime. Better take the subway home after that kind of move, friend ... you may need the cab fare for something more important.

Apparently, the exchanges were all set to approve something more restrictive -- guidelines that would have shut the market if it was down 10% after 2:30 p.m. But the

Securities Exchange Commission

wouldn't hear of it. Seems the sanctity of the U.S. securities market isn't secure unless we're prepared to see a fifth (or more) of the nation's wealth disappear in a day. Didn't they learn anything in 1987? Sounds to me like, "Damn the Brady Commision Report, full-speed ahead!"

It's clear that stock prices will get to where they ought to be, eventually. The question is how quickly they're allowed to get there, and whether the financial system is better served by the mania of a dysfunctional auction market, or a series of planned interruptions, carefully designed to permit all shareholders an opportunity to participate in a reopening after a significant gap.

When

Sotheby's

auctioned Jackie O's belongings, it didn't put the golf clubs and the humidor on opposite sides of the room and solicit bids simultaneously. The right way to maximize the auction proceeds is to get as many people as possible to focus on a single item, the one currently on the block. The only reason the NYSE can pull off a simultaneous auction market for some 2,500 different companies is because most of the trading is a continuous process, even on evenings and weekends.

Why should we care about maximizing proceeds to sellers? I mean, after all, don't these market downdrafts always wind up to be tremendous buying opportunities? Besides, you're only hurt if you sell, right? Wrong! Trading volume on any given day is puny, relative to the number of shares outstanding. Even on the day the NYSE printed a billion shares, that amount represented less than one-half of one percent of the total shares listed by NYSE companies. Just consider: For every 100-share lot that trades, there are 20,000 shares held by other investors.

If you allow the auction market to spin out of control, and absolve traders of the responsibility to provide a rational mark-to-market price for the more than 200 billion shares held by investors, you run a real risk of destroying enough wealth to have an impact on consumers' willingness to spend. An unanticipated and unnecessary recession.

Another budget deficit. Higher interest rates. A higher cost of equity capital. Fewer jobs created. None of these potential results are out of the question.

Just because the "wealth effect" didn't play out in 1987, when the Dow fell 25% in a single day, doesn't mean it won't happen the next time a market typhoon hits. There's much wider participation, and a higher proportion of the national wealth riding on the market than there was only 10 years ago. What's more, as we contend with the Social Security problem, these figures are headed even higher. If we don't mess it up.

Face it. The desire and ability of traders to decide what to buy and sell, and the mechanisms to transmit those orders to the trading post, can easily overwhelm the apparatus for reporting executions and settling them. This was a major problem in 1987, when it took days for some investors to learn whether their orders had been executed, and if so, at what price. Arbitration and legal proceedings dragged on for months. Seems that some of the same problems occurred in 1997, when the Dow fell "only" 7% before closing.

Responsible investors shouldn't have to worry, right? If Warren Buffet can walk away from his quote machine for a month and not worry about his portfolio, I can too, right? Not quite. That's okay if you invest the way he does. It's better if you're as wealthy as he is. What's more, just because the law says all drivers must have insurance doesn't mean that every one does. Responsible investors can be hurt by irresponsible ones.

If your sell order hasn't been executed, you're limited in your ability to partake in whatever bargains may be available. You can easily underspend -- or much worse, overspend -- your available reserves. This is a minor inconvenience if you have funds in your checking account. But what about pension funds, which are prohibited from buying on margin?

Everyone made a big deal about the NYSE's first billion-share day, as if it represented substantial progress over the previous volume peaks (600 some-odd million shares traded on back-to-back days in October 1987). But "turnover," the portion of shares outstanding that traded, wasn't even close. Share splits over the past 10 years make the old record much more formidable, and that's before allowing for all the new issues on the NYSE. What's more, the number -- and importance -- of Nadsaq's listings have increased substantially as well.

On the NYSE, if supply and demand don't balance near the last sale, an "indication" procedure is put into place, summoning any and all players who may be interested in that particular stock to participate in its reopening. This process is much more fair to investors than the hysteria that existed in 1987, and to a lesser degree, in 1997. Problem is, you can't go through the indication process for every stock ... or can you? Don't get me wrong -- I'm a big supporter of free markets. I like deep, liquid markets that provide attractive investment opportunities for the broadest possible group, besides being a healthy conduit for capital to flow to deserving companies. An important part of that ideal market is a coterie of active, enthusiastic traders. Most of the time, the system works extremely well. Occasionally, though, it breaks. I've been there when it's happened.

The right approach to dealing with the discontinuities is to halt trading, publicize the concerns, seek information from the underlying companies, advertise the imbalance, and give the owners of the other 200 billion shares an opportunity to enter orders, and have a say in how their companies are priced. And if you have thousands of complaints that people can't get through to their brokers after a 7% drop, you're begging for trouble by replacing that circuit breaker with one that won't trip until the Dow's off 20%.

Tom McManus, a veteran Wall Street strategist, is an occasional contributor to TheStreet.com. He welcomes your feedback at

tmcm@tmcmanus.com.

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