What was the Wall Street wipe-out all about?

Did you see what happened on Wall Street last night? For a few minutes, it was very scary stuff.

While we were fretting about the election, US shares went into freefall. At one point, the Dow Jones Industrial Average dropped by more than 9% in a 1,000-point plunge. Even some big blue chips sank by over 50%.

And although the index then bounced back, it still closed over 3% lower.

So what on earth was going on?

Stocks were heading down anyway. US investors have begun fretting about how widely Greece’s woes could spread. Commodities guru Jim Rogers said stocks were “overdue for a sell-off”. And Marc Faber of the Gloom, Boom and Doom report said it was time to trim holdings as “the market was overbought, ahead of itself and due for a correction”.

But then the gremlins got in, in droves. “Computerised trades sent to electronic networks turned an orderly stock market decline into a rout, according to Larry Leibowitz, CEO of NYSE Euronext”, says Bloomberg.

And that’s where it gets technical. Stock market trading has moved on a long way from the days of chaps wearing top hats.

Nowadays, some 60% of US share volume is carried out via computer-driven, high-frequency trading. This uses complicated computer algorithms, based on a range of outcomes, to trade automatically at speeds of millionths of a second.

And while the likes of pension funds are doing the deals, in many cases there’s no one pressing the button. The machines do it all because they can act much faster than people.

Like everything else to do with technology, it’s great when it works. But when the machines take over, as we saw yesterday, all hell breaks loose.

No one yet knows how it started, if it was caused by a huge error, if it was done deliberately – or if it will happen again. But the financial fuzz are now getting stuck in. Both the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission say they’ll be looking at “unusual trading” patterns. And at least the exchanges are cancelling some of the most suspicious trades.

America’s politicians want their say too. “This is unacceptable”, says Democrat Paul Kanjorski. “We can’t allow a technological error to spook the markets and cause panic”.

“The potential for giant high-speed computers to generate false trades and create market chaos reared its head again”, says Senator Edward Kaufman. “The battle of the algorithms – not understood by nor even remotely transparent to the SEC – simply must be carefully reviewed and placed within a meaningful regulatory framework soon”.

Of course, we’ve been told all this before. The 1987 crash was widely put down to “programme trading” – the 1980s equivalent of the today’s high-speed algorithms – getting out of control. And the clever clogs were supposed to have stopped it happening again.

But they clearly haven’t. And I’ve no faith that they will in future. That’s because, despite what the regulators say or do, the traders are always at least one step ahead of them.

And regardless of what we’re told by the experts about a computer programme being infallible, it almost certainly isn’t. That applies to analysis models as well as to black-box trading schemes.

So what’s the bottom line?

There’s nothing that you, the individual investor, can do about dodgy computerised trades. But you can protect yourself from the fact that the underlying fundamentals don’t look good. We agree with Rogers and Faber that stock markets generally look both over-expensive and ‘toppy’. And we’ve been expecting an overall pullback, particularly in the US.

So if you’re in the market, we’d stick with the big, defensive blue chips. And if you haven’t already taken profits on your cyclical stocks, it’s probably worth doing so.