Computers and nincompoops...

Other than folks getting scared out of the market and/or taking profits, what else might cause the sort of downward volatility we've seen of late? Two things come to mind: computers and nincompoops.

When I say computers I'm talking about trading programs: Algorithms set to sell large blocks of shares for some institutions when some technical support line (might be simply a level of the S&P, might be the level in relation to the 50-day moving average, might be something else) is breached. Let's say the market begins declining when the ISM manufacturing index comes in soft (inspiring traders to unload a few shares), followed by the tanking of the Turkish Lira, inciting yet more selling to the point where the S&P 500 pierces a key support level and sets off a computer-selling frenzy. Bam! The Dow drops another 300 points and you're thinking What the hell's going on!! Why is everyone bailing out on one soft data point and the dropping of the currency of a country with a pimple on a gnat-sized economy? (Actually, Turkey's economy isn't all that tiny (relatively speaking), it's the 17th largest in the world. You just thought it was tiny).

Well, in reality, everyone (in my example) isn't. In fact, given the inanimateness of a computer program, nobody is (yeah, I know, an animate being established the program and didn't get in the way when the sell signal approached. Just go with it). And you're sitting there thinking investors are in a blind panic. Not that a computer-selling frenzy couldn't incite blind panic---in which case you'd be selling the farm to buy all the stocks you can get your hands on, right?

When I say nincompoops I'm talking about the euphoria-ridden folks who were so naive late last year as to think that one of the longest correction-less market rallies in history had the moon left to go. Their naiveté hit such an extreme that they hit their brokers up for margin loans against their accounts. That's right, you (not you, of course you wouldn't) can actually borrow from your brokerage house against your brokerage account, typically as much as 50% of your account's value.

Example: You (not you) have an account with stock positions totaling $100,000 and you think the market's going to the moon and you want all you can get. So you call your broker, he/she gets you the paperwork needed to make yours a margin account, and you borrow the max. You end up with $200,000 worth of stocks. $100,000 you bought with cash, $100,000 with borrowed money.

Now what happens? Well, if you're right you pay a little interest, but you net a mountain on your way to the moon. If you're wrong, your equity drops below your brokerage house's required minimum---and your rep has your cell number. You receive the dreaded proverbial margin call. It goes like this: "Hey you, your account's equity has tanked along with the market, so we need you to pay down (or off) that loan immediately. Can you get here first thing in the morning with a $XX,XXX check?" You pretend your connection's bad, power down your phone and head straight for the liquor cabinet. You then pray that the rally of all one-day rallies occurs tomorrow and sends your account back into the black. What you didn't stay on the line long enough to hear was your broker telling you that if you can't do the check he needs you to instruct him as to what to sell to square your account? Of course without your instructions the selling's gonna happen anyway.

The bottom line is that stocks that might not have otherwise been sold get sold. And when it happens en masse, like when margin debt is really high---like it was at the beginning of this year---the market takes an additional, and perhaps un-fundamentally-deserved, often dramatic, hit. And when it's un-fundamentally-deserved the market tends to correct in the opposite direction (up) in a hurry---therefore it's generally a very bad idea to react to the occasional dramatic hit.

Am I suggesting that the extent of the recent pullback (which, honestly, hasn't been all that much) is at all the result of either or both of the above phenomena? I suspect a little. But regardless, good fundamentals or not, the only thing that keeps a bull market (if we're still in one) healthy is a good correction every now and again. So then, I guess computers and nincompoops---when you (yes you) are not influenced by either---aren't such bad things after all...

P.s. When we experience that crazy seemingly-unjustified snap-back rally I'll be back to describe yet another kind of nincompoop---the naive short-seller...