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More Interconnectedness, More Volatility

More complexity and interconnectedness could destroy the market unless immediate changes are made.

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



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.

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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.

Here are some of the changes in the system and our society which make increased volatility more likely:

  • Immediate Information. We all have instantaneous access to information. The vast majority of the time this allows us to make better decisions. However, it can also encourage herd-like behaviors. When a few dozen people in Greece start getting violent, and we all see the same images on TV, we sell positions at exactly the same moment.
  • Complex and Powerful Computers. We have much cheaper and more powerful computing power today, compared with even seven years ago. Some use this power to do more analysis of stocks or market dynamics. Some use it for high-frequency trading and other complex algorithmic models. I'm not against high-frequency trading, yet its existence can lead to more severe "falling domino"-like moves in the market. In the case of the alleged Universa "black swan" trade last week, it is conceivable that Universa's buying 50,000 puts on the S&P June futures to go to 800 could have led to a cascading series of sell orders by other actors in the market which accelerated the sharp move down.
  • An overreliance on the same financial models. Groupthink has always existed on Wall Street. It moved us up during the dot-com bubble and it moved us down when that bubble collapsed. The problem with groupthink in today's market compared with 10 years ago is that the velocity has increased so much. Today, when everyone suddenly decides to move from one side of the boat to the other, there are no safeguards in place and the boat can easily tip.
  • The Trader's Mentality. Although there will always be buy-and-hold investors in the market, it's fair to say that to succeed and thrive in these new market dynamics we all have to be traders now. You have to be a little more ADHD than you used to be. You have to take profits sooner. Again, there's nothing wrong with that. But it means that more market actors are on edge. When some new immediate information is released -- like the scenes of the Greek protesters -- it's sell now and ask questions later.
  • Interconnected counter-parties. Whether we're talking about Goldman Sachs (GS) and others that would be on the hook if AIG (AIG) failed, or the banks which loaned to Greece that would be impacted by a default, it's clear that companies or countries don't die alone anymore, they take their counter-parties with them. We have interconnections across our financial system that market actors and regulators aren't even aware of.
  • Unregulated exchanges. We have the New York Stock Exchange slowing down its trades last week during the chaos, while Nasdaq and others proceeded full steam ahead. There has to be a common set of rules for all to follow.
  • Leveraged Exchange-Traded Funds. With double- and triple-leveraged ETFs existing today, large flows into and out of these funds can have dramatic moves on particular stocks or industries. It adds yet another layer of volatility to the mix.

What's the solution?

Well, we're not going to put the genie back in the bottle and get rid of the Internet or our addiction to information. However, we can make some improvements to help the system including:

  • Bringing back the uptick rule.
  • Agreeing on the same "circuit-breaker" rules for all exchanges to follow.
  • Abolishing double- or triple-leveraged ETFs.
  • Bringing credit-default swaps onto a listed exchange.

Even if all of these changes were implemented, we would still be a market that is much more "trigger happy" than we were a decade ago. But at least the system would be less volatile than it is today.

At the time of publication, Jackson was long Citigroup.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. You can follow Jackson on Twitter at or @ericjackson