Thursday’s 15 minute crash; Kotok’s polemic

David R. Kotok, Cumberland Advisors

May 8, 2010

America’s stock market turmoil scared the “H” out of everybody this week. Part of it was a serious 8% (so far) correction which was long overdue. Markets do not go up or down in straight lines. This one has been in a strong uptrend since the March 9, 2009 bottom. The market’s correction started from an interim top on April 26.

In the midst of this correction we witnessed a 1000-point drop of the Dow. Most of it occurred in 15 minutes in the middle of Thursday afternoon. The subsequent 600-point 15 minute reversal only complicated investor’s perceptions. This bizarre market behavior leaves them quite unsure of the future.

American’s confidence in Wall Street was already low. It is now eroded even more than before. Thursday’s drama comes on the heels of the last three years of financial-system failure in the United States. It piles on the sequence of Countrywide and WAMU, Lehman, Fannie, Madoff, Goldman, etc. Ugh! What a blotch on American history!

In Thursday’s sell-off we saw transactions that made no sense. I personally witnessed the trading in an ETF that is composed of an equal-weighted basket of the 500 stocks in the S&P index. The symbol is RSP. It traded from 40 dollars a share down to 10 in a straight line. Of course that price was not due to any accurate valuation; it was an error. It was driven by electronic interfaces and did not involve humans. It was later rescinded. The New York Stock Exchange invoked a procedure called the “Clearly Erroneous Execution Rule.” It permits the exchange to cancel trades of this type. There is no appeal from their decision.

The NASDAQ canceled trades in 281 securities. 193 of them were ETFs, according to Matt Hougan of Index Universe. Matt is a recognized expert on ETFs.

Let me be clear. I do not want to single out Rydex and RSP. Nearly all ETF sponsors had canceled trades. For example: iShares, Wisdom Tree, SPDR, and Claymore were among the list of the 193. The key takeaway is that the arbitrage mechanism and creation unit system of the ETF process failed miserably for those investors who do not understand it.

This was a warning to ETF investors who use stops without thinking about them and who trade ETFs without comparing the price to an accurate estimate of the specific ETF’s net asset value. Simply put: if you do not know what you are doing, you are playing with fire and can get burned. Many did on Thursday.

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David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com

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