The Latest Trading Glitch Sending Mr. Market on a Wild Ride

Remember that crazy "flash crash" of 2010? It's baaaack!

Thanks to trading firm Knight Capital (NYS: KCG) , today we were treated to a showing of "Flash Crash II: The Revenge." NYSE Euronext was reviewing the trades of 148 companies -- including Alcatel-Lucent (NYS: ALU) , SandRidge Energy (NYS: SD) , Molycorp (NYS: MCP) , and Annaly Capital Management (NYS: NLY) -- after odd trading activity.

Molycorp shares, for instance, plunged 17% while trading reached 8.6 million shares as of this writing. Molycorp's average daily trading volume has been 2.7 million shares, and the company did not release any substantive news today. Similarly, shares of Alcatel-Lucent were swinging wildly on heavy volume this morning on no news.

This flash-crash-esque screw-up didn't pack nearly as big a punch as the original, which sent some shares plummeting all the way to $0.01 and dragged down the entire market. But the reaction has been just as overblown.

Oh, the humanity!
As machines took another opportunity to remind us that they're not perfect -- particularly as long as they have to be programmed by humans -- many market commentators took this opportunity to remind us just how shaken individual investors are and lament that this will only exacerbate that.

The Wall Street Journal noted that the issue was "raising concerns that another technology problem may dent investor confidence." The Financial Timeswent further (free registration required):

At a time when retail investors show no sign of reversing their massive retreat from equity mutual funds, which accelerated after May 2010, the latest episode of an algo malfunctioning will do little to reverse the lack of trust in how the stock market currently operates.

The FT also quoted Themis Trading co-head Joe Saluzzi, who said:

When the price discovery process breaks down, investors can no longer trust the markets... The plumbing of the stock market has changed so much that it's hurting and destroying the price discovery process.

Mistakes: Where do we start?
Taking the easy mark first, I'll quickly point out that despite the continued drumbeat from the media that Average Joe and Jane Bagadonuts have lost confidence in the stock market and are no longer investing... they are. My fellow Fool Morgan Housel tackled this back in May using facts and numbers (imagine that!) to show that there's been no huge individual-investor exodus from the stock market.

As far as the psychological impact of the latest "attack of the trading machines," there are two parts to the question. First, will this hurt confidence? And second, should this hurt confidence?

On the question of will it hurt confidence: If we go back to the 2010 flash crash, average S&P 500 trading volume was 2.4% higher in the three months following the blip versus the three months prior to it. It certainly doesn't look like the big robot-induced dip convinced people to stop using the markets, so I don't see why its punier younger sibling should.

To be sure, the media will pull its hair out for a day or so over it, which slightly increases the likelihood of a reaction from investors. However, the ADD nature of the financial media means that a new news cycle will quickly blow in and this will be tossed in with Peregrine Financial as news that is soooo yesterday.

But should it bother us?
It's much more interesting to consider whether this should hurt investor confidence. If we revisit Joe Saluzzi's take from above, there are at least a couple of interesting things to note. First, Themis Trading's website makes it clear that they're deeply suspicious of the impact of electronic and high-frequency trading. This makes sense, as the rise of the machines has taken a toll on the ranks of traders. A big screw-up from a trading machine is a great opportunity for a guy like Saluzzi to jump in front of a mic and remind us why we need human traders. We can't blame him, but we can probably chalk this up partly to talking his book.

And though Saluzzi says "investors," he's not an investor; he's a trader. For a trader, wild unpredictability like this is bad news because wild, unpredictable moves lay waste to a trader's intuition about stock movements earned from decades of experience. This is particularly concerning when they have an institutional customer breathing down their neck to make a big transaction.

I don't mean to pick on Saluzzi or Themis in particular; this applies to trading/traders in general.

But for individual investors -- true investors -- this isn't nearly as concerning. Call me lazy for going back to Warren Buffett, but a couple of his quotes are all too fitting here:

Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.

If you're investing with this kind of perspective, some wonky trading because of a computer algorithm gone awry isn't something you lose sleep over.

More generally, though, investors shouldn't be counting on the market to tell them how much the stocks they own are worth. Investors should be doing the work on their own to figure out how much their stocks are worth. The stock market is simply a place to transact -- ideally, buying when a stock is underpriced and selling when it's overpriced.

So let the media have its Chicken Little episode with this mini-flash-crash. But sleep well knowing that, if anything, stupid robot tricks in the market will create opportunities for those able to keep their heads on straight.

On that note, are you looking for the types of stocks worthy of holding through a 10-year market shutdown? A good place to start is with the three Dow stocks that my fellow Fools highlighted in this special report: "The 3 Dow Stocks Dividend Investors Need." You can grab a free copy of that report by clicking here.

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