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Karolyi’s insights into “The madness of Wall Street” wash world-wide media

Johnson’s professor of Finance & co-academic head of the Emerging Markets Institute (EMI) discusses his upcoming research and the danger of “liquidity black holes”

Karolyi's insights into

Excerpt from “Insight: The Madness of Wall Street” (Reuters/New York Times, Aug. 19)

Experts say investors should expect even more volatility in stocks, as herd trading by hedge funds, knee-jerk trader reaction to news and lightning fast computer programs combine to make for a new and uncomfortable normal on Wall Street.

This new trading frontier even has its own signature milepost, something called “a liquidity black hole.” It’s a trading phenomenon in which there’s so much intense selling pressure in big-cap stocks that it sucks all the oxygen out of the market and stocks plunge precipitously – as on August 8 when every single stock in the S&P500 ended the day in the red.

“We have to be aware that we can be hit by one of these liquidity black holes with ever increasing frequency,” says G. Andrew Karolyi, a finance professor at Cornell University Johnson Graduate School of Management. If you are a long-term buy and hold investor you better be aware of these and not panic when you see it.” …

Karolyi says the waves of wholesale selling driven by liquidity black holes are not just the byproduct of the over-computerization of trading, it’s the end result of too much “group think” by institutional traders.

He says Wall Street first saw this in August 2007, when dozens of quant hedge funds suffered big losses at the start of the financial crisis because the algos they employed were all buying and selling the same securities. This flawed thinking by some of Wall Street’s brightest math geeks was an early warning sign of even worse group think to come with regards to the value of securities backed by subprime mortgages.

Karolyi says his research, which will be officially published later this year in The Journal of Financial Economics, has found the phenomenon of liquidity black holes is spreading beyond the U.S. to other stock markets. That is problematic because the effects of liquidity black holes can be profound.