Knee-jerk reaction to market’s free fall should be avoided

The Securities and Exchange Commission and the various stock exchanges must resist the temptation to react impulsively to the market meltdown that occurred May 6. This time, let’s first examine the patient to

diagnose the disorder before prescribing the cure and beginning treatment. This isn’t the course being followed by Congress in the broader financial-reform efforts prompted by the mortgage crisis. In fact, financial-reform legislation is nearing completion, while the Financial Crisis Investigation Committee is only halfway finished examining the causes.

The result will no doubt be misdiagnosis, mistreatment and unintended consequences that may be harmful to investors.

If the proper course of action is followed — examine the evidence, diagnose the cause and prescribe the cure — the probability of getting the fix right will be greatly improved, and investor confidence may actually be restored.

A sense of proportion would also be helpful.

Yes, the 1,000-point drop of the Dow Jones Industrial Average in less than an hour was heart-stopping, but the decline at the end of the day was only 347 points, and the 1,000-point drop was less than 10%. It wasn’t even half the 22.6% drop that the index experienced on Oct. 19, 1987.

The stock market survived October 1987, and it will survive May 6, 2010.

Nevertheless, many investors are shellshocked by the market’s volatility over the past three years, and for many, the events of May 6-7 were the final straw. They may abandon the stock market forever — or at least until they are confident that they won’t be victims of more sophisticated investors’ taking huge gambles based on non-public information.

The SEC must thoroughly examine the evidence, determine what caused the dive and decide what action is most likely to prevent a recurrence without imposing significant costs on investors.

Already, a number of differing explanations are floating around.

The first proposed explanation was that a trader mistyped an order to sell a large block of shares of Procter & Gamble Co., increasing the size of the order by a factor of 10, causing panic selling, which in turn triggered computerized trades. A more recent explanation, reported in The Wall Street Journal, is that a large, bearish options trade on an index by a hedge fund triggered additional bearish trades by high-frequency traders, dragging the markets down.

Actions to prevent a recurrence of the first explanation would be simpler than actions to prevent a recurrence of the second.

Simple changes to trading programs could flag trades that appear to be out of the norm. Also, the uniform stock-specific trading halts, already proposed by the exchanges and likely to be implemented soon, would help buy time in a crisis and allow for calm to be restored.

But to prevent an index option trade by a hedge fund from triggering more high-frequency trading might require limits on some types of high-frequency trading.

It is also possible that neither of these explanations is correct and that more investigation will reveal the true cause — weaknesses in the current market structure that require repair.

A slow, thorough investigation will serve all investors better than a rush to judgment and ill-conceived action.