Chasing the Same Signals: How Black-Box Trading Influences Stock Markets from Wall Street to Shanghai

Chapter 1. The Canary in the Coal Mine

How the First Signal of the Financial Crisis Wasn't Noticed

A year before the financial tsunami of October 2008 materialized and the words "subprime mortgages" became common language ingrained in our evening news, there was a subtle warning in the financial markets that the world's global economies were not in a state of balance. The warning materialized in the first week of August 2007, when global equity markets observed the worst stockmarket panic since Black Monday in October 1987. But nobody noticed.

On the morning of August 6, 2007, investment professionals were baffled with unprecedented stock patterns. Mining sector stocks were up 18 percent but manufacturing stocks were down 14 percent. It was an excessive 30 percent directional skew between sectors, yet the S&P index was unchanged on the day.

The next few days would continue with excessive stock volatility and dispersion patterns. MBI Insurance, a stock that had rarely attracted speculation would finish up 15 percent on August 6, followed by another 7 percent on August 7, and then finish down 22 percent over the subsequent two days. The rally in MBI was nothing more than an aberration as the gains reversed as quickly as they appeared.

Conventional wisdom suggests markets are efficient, random walks—stock prices rise and fall with the fundamentals of the company and preferences of investors. But on August 8, the housing sector would be the best performing in the market with a gain of 22 ...