Are Computers to Blame?

If big investors are determined to panic, computers can sure help. A few keystrokes into a broker's desktop computer can trigger the sale of thousands of shares of, say, 500 different companies. Such "program trades" may have played a role in making Black Monday the worst day in Wall Street history. As one Chicago broker joked, the difference between 1929 and 1987 is that last week, it was the computers that jumped out the windows.

But how much are the computers to blame? That issue stirs a great deal of confusion. The term program trading is misleading: it derives not from the fact that trades are executed by computer programs but that they involve the systematic sale of portfolios of stocks as if they were one stock. The first program trades, executed in the early 1970s, did not involve computers.

Program trading came into its own in 1982, with the advent of stock-index futures. These enable investors to make a bet on which way the entire market is going. Index futures, used with program trades in the stocks on the index, open up a variety of opportunities. One of the most popular takes advantage of momentary differences between the price of a futures contract and of the stocks themselves. When this spread is sufficiently wide, a trader can lock in a profit at no risk by, say, buying the futures and selling the underlying stocks. This practice, called index arbitrage, has been blamed for the sharply increased volatility of the market, though the point has never been conclusively proved. Indeed, some experts believe index arbitrage actually reduces volatility by helping the market reverse course when it goes too far in one direction.

But most arbitragers were on the sidelines last Monday because the computers that track prices had fallen hopelessly behind. The real culprit was a variation of program trading called portfolio insurance. This is a defensive strategy designed to protect stock portfolios against market downturns. Rather than sell stocks as their prices are falling, portfolio insurers sell stock- index futures. If the decline persists, the futures can be repurchased at a lower level, yielding a substantial profit that will offset some of the loss sustained on the stocks. But traders who buy the futures hedge their positions by making computer-aided sales of the underlying stocks, driving the market down further. If computers did help accelerate the Black Monday slide, they were not responsible for it. As an IBM executive once said, "Computers don't kill stock markets. People do."