With Nasdaq's three-hour outage last month still fresh in many investors's minds another milder outage hit this week, and Wall Street is bracing for more possible market disruptions with the arrival of hurricane season. Last year's Superstorm Sandy led to the longest U.S. weather-related stock market shutdown since 1888.
It's the latest in a series of worrying breakdowns in the market's underlying infrastructure. "Flash" events – those wild swings or shutdowns spurred by a combination of volatile algorithmic trades and old-fashioned herd mentality – have rekindled fears of the market crash of 2008 and other financial calamities. But most of the one-day disruptions, either from weather or computers, end up having little lasting impact. The biggest danger for investors is to overreact to the scary headlines.
The latest NASDAQ OMX, which operates the Nasdaq exchanges, says there was "a six-minute outage" involving a data feed failure that was "promptly resolved." Such issues come at an inopportune time for the exchanges as the head of the Securities and Exchange Commission, Mary Jo White, has summoned stock exchange leaders to Washington next week to explain such outages, which she calls "serious." Keeping exchanges running, she says, is "critically important to the health of our financial system."
It's big news on Wall Street, to be sure, and professional traders who participate in the market are watching closely. But do average investors need to worry?
"Unfortunately, average investors who flip on the TV and hear that the Nasdaq is closing for three hours often freak out," says David Edwards, president of Heron Financial Group. "Some bail out of the market, and the problem is that if they do that, they bail out on their retirement, too."
The Nasdaq shutdown on August 22 made headline news and was quickly dubbed the "flash freeze," differentiating it from the much-debated "flash crash" that put stocks into a nosedive on May 6, 2010. Both came at about the same time of day, near 3 p.m., but they shared little else in common. In the freeze, trading came to a complete halt, and in the flash crash, stock prices tumbled 1,000 points, though trading continued and shares rebounded quickly.
But do such events mean the stock market's structure itself is dangerously brittle? Not necessarily, strategists say. Fran Kinniry, a principal at Vanguard Investment Strategy Group, says the fact that these events are newsworthy shows how unusual they are and, counterintuitively, how reliable the markets have become. There is always a chance of a market tumble, and there is rising uncertainty about the economy as the Federal Reserve gradually begins to pull back after five years of easy credit.
When the market hits one of its wild patches, it's never clear whether it's a temporary glitch or some fundamental problem. But at least by one key measure, the market is in a calm state: The VIX volatility index is now down 75 percent from its 2008 level to a level that is normal by historical standards. Indeed, short-term traders who like wilder market conditions complain that it's too quiet.
"The market has done an incredible job of being open as much as it is," Kinniry says. "With the recent 'freeze crash' or the big ['flash' crash] in 2010, if you did nothing, it was a non-event."
Investors who react too quickly can hurt themselves in flash events. "The best reaction for most people is to go about your normal business and activities and try not to react to these temporary situations," Kinniry says. The market, he adds, is "highly efficient," and when computer errors or shutdowns occur, the market usually corrects for the error.
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"I always tell people the market shuts down every weekend for two days," Kinniry says. "And we come in on Monday and everything is okay."
Edwards, who has served on legislative and regulatory committees of the Investment Adviser Association, says, "You should not even notice something like this because you should have a five-year holding period for the stocks you buy." But he concedes that bigger investors have cause for alarm since a momentary crash or the inability to complete a trade could cost them millions of dollars. "This is really just an issue for institutional investors," Edwards adds. "You don't really need instant liquidity. You don't have that with your house or your job or anything else in your life."
Beyond the problem of computer failures, the market could face more disruptions from the uptick in storms over the past decade. Hurricane Sandy showed that Manhattan's subterranean wiring and transportation are more vulnerable than previously thought. For the record, the National Oceanic and Atmospheric Administration sees an above-normal to "very active" storm season this fall.
But because most real trading is done virtually, without any market floor, even big weather events tend to have minimal impact. The market managed to reopen after the two-day shutdown from Sandy in October 2012, and since then investors have shown confidence in Wall Street by putting more money into equity funds than they have since the 2008 crash.
To be sure, the markets need to address the mysterious computer "flash" failures like the one in May 2010, Edwards says. It caused a 9 percent drop in U.S. stocks in a few quick minutes. The August "flash freeze" this year brought the $6 trillion Nasdaq market to a standstill for three hours.
But the big numbers thrown around about losses are misleading, Edwards adds. The snap calculation in news reports that the 2010 "flash crash" created a $2 trillion loss in less than 30 minutes alarmed people. But that was a theoretical value based on all of the $20 trillion worth of U.S. equities being bought at the day's high and sold at the day's low. In fact, prices sprang back quicker than people could react and soon returned to where they were before the computer glitch. Few investors felt any direct impact.
"The severe dislocations observed in many securities were fleeting," said the official report on the "flash crash" from the Securities and Exchange Commission and Commodity Futures Trading Commission. To be sure, it showed the interconnection of the markets and how vulnerable they can be to viral events. But ultimately, the market passed the flash tests, showing that "prices are adjusted back to their true level almost instantaneously when they get out of line," Kinniry says. Volatility measures have continued to decline over the past two years, showing that the disruptions are being taken more in stride.
"The best advice for long-term investors is to not react to these kind of things," Kinniry says. "Typically they resolve themselves. I hate to promise anything, but that's been the history."
Updated on 09/05/2013: This story was originally published on September 4, 2013.