Flash Crash, Goldman Sachs & Bitcoin

Flash Crash, a story of the mysterious market crash in 2010, describes events related to the trading of S&P500 futures, the effect of high-frequency trading, one man's attempt to fight back & the legislative challenges of regulating a market in an era where technology and algorithms dominate. There is one conversation, which takes place during a Senate Banking Committee hearing, included in this book which is of critical importance to the surrounding discussion, between Senator Jack Reed and the Chair of the SEC, Mary Schapiro:
    Senator Reed asks: 

    "The presumption of most people who own a few stocks is that the value of stocks, the liquidity of stocks is directly a function of their economic value, the same thing with debt instruments and derivatives. One of the issues we have to deal with is, with the proliferation of these algorithmic, high-frequency traders, some of these algorithms don't take into account the fundamentals of the instrument, the economic value, the dividends, the status of the municipality issuing them. They are simply saying 'if enough of these are sold we start selling, and then if we start selling another algorithm kicks in'. To the extent that we get further away from economic values here, does that not only cause concern but is that something that’s good for the economy? It may be a naïve question but I'll pose it."

   To which Schapiro replies: 

"It's not a naïve question at all. It's sort of the fundamental question we're all grappling with."

    In Flash Crash, Vaughan describes Reed as having "shifted the conversation from the practical to the philosophical" and, almost a decade on from that hearing, the issue is still relevant, if not more so. The coronavirus pandemic has shut down economies worldwide. Many businesses no longer trade. The futures of many industries (hospitality, travel) are in doubt altogether. Despite this, many stock market indices have shown minimal damage. The Nasdaq 100 set a new intraday record on the 6 June, becoming the first major US index to completely recover from any impact of the coronavirus. According to Finimize on the 2 June, US stocks are up almost 40% from their March lows and only 10% away from all-time highs. With massive shutdowns still affecting large parts of the US, it is surely unlikely that the economic value of these stocks is reflected in the stock market prices. This viewpoint has been echoed by legendary investors such as Stan Druckenmiller and David Teppen, with Teppen claiming in May that the equities market is the second most overvalued he has seen, after 1999. Even beyond the COVID-19 lockdown, there are ongoing protests in most major American cities following the death of George Floyd. This disruption has also had no negative effect on the markets, as Fox News pointed out with a deplorable graphic comparing several historical deaths of black men with the subsequent effect on the S&P500. This would suggest that the stock market is not being valued on economic value as economic factors surely suggest the opposite; staggering unemployment figures, a shrinking economy, and domestic riots surely point to lower levels of economic activity which is not being reflected in the stocks. This would suggest that Senator Reed's question is still relevant and perhaps we have strayed further from the true economic values of stock prices (calculated from future cash flows, dividends, and asset value) and the prices are instead purely a reflection of confidence. 

    This is also worth considering when seeing information given during a recent presentation given by Goldman Sachs concerning investment opportunities in the current climate. Amongst those considered was Bitcoin. They "believe that a security whose appreciation is primarily dependent on whether someone else is willing to pay a higher price for it is not a suitable investment for our clients." This statement, considering the previous points, seems somewhat hypocritical. Of course, the businesses that make up the stock market indices are, even excluding any cash flows or revenues, worth at least the value of their assets, which cannot be said for bitcoin as it holds no intrinsic value. This being said, it would seem that the economic value (in terms of its academic calculation) is no longer the driving force behind these valuations. It would also seem that the very principle which renders bitcoin an unsuitable asset is the exact principle that draws in day traders who trade S&P500 futures. It is precisely this activity that led to the conversation between Senator Reed and Schapiro that inspired this blog post. This debate surrounding Bitcoin should be considered in the broader context of investing entirely. Surely any investment is dependent on someone being willing to pay a higher price for it in the future. The point that Bitcoin not holding any intrinsic value would be a valid criticism if all other investment opportunities were primarily dependent on their economic value, which is surely questionable. 

    I am aware that I may have oversimplified the nuances of equity valuation and ignored the performance of individual companies in favour of using market indices as a representation of the stock market and I may be entirely naïve in my outlook but it would seem that the philosophical debate considered in 2010 still applies completely and the links between market performance and actual economic health seem further apart than ever, at least on a surface level. 


Luke Sawney

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