Wednesday, October 1, 2008

Market Mechanics Trumps Reason

If you thought the prices of securities were determined with precision by the aggregate knowledge of market participants, and behaved as an invisible hand to lead shares to their proper values, NASDAQ has bad news for you. On September 30, 2008 the share price of Google (GOOG) did this number:

And the reason GOOG's chart plummeted below 225 and soared above 475 wasn't a sudden new series of understandings reaching the market ove the course of the day, it was another marketplace sending erroneous sell orders representing a large number of shares for sale on the NASDAQ trading platform. If reason and not market mechanics guided the immediate-term price of securities, these irrationally-priced trades would have not been undertaken. However, GOOG was so mispriced by the flood of shares seemingly on offer, and reacted with such abandon in the aftermath as it soared through the roof, that NASDAQ canceled all trades outside the range of $400.52 (the new close) and $425.29 during the period 3:57PM-4:02PM EDT. The whole range -- 225 to 475 -- was displayed from the price-rewriting point three minutes before four.

The ability of artificial for-sale share volume to induce both an immediate-term collapse in price and create frightening volatility for investor market participants is something the SEC needs to keep in mind as it continues its policy of non-enforcement of the most basic principle of markets -- that sellers must deliver what they purport to sell. So long as sellers are permitted in effect to print phantom shares without limitation, because they need not produce certificates so long as they close a position within three days of entering a trade, the markets cannot be counted on for anything like rational pricing. Given that artificial sale volumes can do to a wildly profitable and well-known international enterprise in three minutes, three days is an effective eternity for price manipulation.

But the point of this piece isn't that the SEC has its head stuffed into a dark orifice, but that markets do not display rational pricing all the time.

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