CHICKEN LITTLE REVISITED

Presented before a group of New York-based members of the Chicago Mercantile Exchanges
New York, New York,
February 1988.

This parody, written in the aftermath of the 1987 stock market crash, was inspired by one of our many trips to the East Coast to meet with executives of the major securities firms of the New York Stock Exchange.

Sometimes, sitting on the airplane on the way back to Chicago, I was struck by the obstinate, pious, and blind refusal by otherwise highly intelligent and successful members of the U.S. financial world to accept that index arbitrage was simply a market mechanism and not an inherently evil strategy whose only purpose was to lower stock prices.

When I first began working as a runner for Merrill Lynch on the old floor of the Chicago Mercantile Exchange, I was about as green as you can get. I knew nothing about futures, and was equally ignorant about all aspects of the marketplace. But that did not disqualify me for my new job. As a runner I wasn't required to know anything. Besides, I would learn. My school, so to speak, would be all around me—what I would see and hear.

The process worked. My teachers were my contemporaries, those clerks and runners on the floor of the Exchange who had been there at least a day longer than me. I idolized every one of them and hung on their every word.

The dean of our little band was a clerk named Peter who was much older and had been there longer than any of us. In fact, I recall wondering why he was still a runner, but dismissed the thought on the basis that I really didn't understand how the system worked. Besides, it didn't matter since, to my good fortune, Peter became my friend. He was a very serious fellow who spoke with a keen sense of authority and knew everything. In short, Peter's word was gospel.

One day Peter swore me to secrecy and divulged why he was still a runner. "It is the best place to learn," he said in a whisper and explained that as soon as he learned everything he would become a trader and make a million dollars.

Since it was clear that I was trustworthy, Peter imparted to me still another secret, a discovery that, in his words, "was bound to make me a ton of money."

"I call it," he confided with a measure of pride, "the pink law of market dynamics."

"Wow," I exclaimed, duly impressed, "what does it mean?"

"It means," he whispered, looking about to see if anyone was listening, "it means that colors control the direction of the market."

"The direction of the market? You're putting me on."

"No I'm not," he said emphatically, "colors control."

"You mean a color can make a market go up or down?"

"That's right," he nodded solemnly, "it's a discovery I've made about market dynamics. I know for a fact the color pink makes the market go lower."

There was an embarrassing moment of silence while I pondered the revelation and then shamefully admitted I was a dunce and didn't quite get it.

Peter smiled and with a fatherly pat on my back told me not to worry. "In time you will understand."

In fact, years later I did understand.

It seems that Peter was working for a major brokerage firm that had hired a new floor manager. The new manager was innovative and adopted a unique procedure to help brokers quickly execute the firm's business. The new policy required that all "buy" orders be written on blue order forms and all "sell" orders be written on pink order forms.

In Peter's mind, the procedure took on a deeper meaning. After all, no sooner would he deliver a pink order to a broker, then the market would tend to go lower. (Sell orders do have this curious effect on a market.) Over time, to Peter, the color became the controlling element. Pink was no longer the messenger, the vehicle. Instead pink assumed the substantive role. Pink became the reason for the market's decline.

Years have passed. Believe it or not, Peter's unique sense of logic did not hamper his success in the world of markets. Today, Peter is chief clerk for a fund manager managing billions of dollars. By accident, I ran into him the other day and, after reminiscing about the good old days, I jokingly asked him if he remembered his old pink law of market dynamics.

A knowing look crept into his eyes. "Damn good law," he said lowering his voice, "except that its applicability is much broader than I realized at the time. It goes far beyond the color pink."

"Like what?" I asked, ready to go along with the gag.

"Like index arbitrage," Peter responded with conviction.

"Wait, let me guess. You mean index arbitrage makes the market go down just like the color pink does?"

"You bet."

I hesitated. "Peter, you can't be serious?"

"You bet I am."

"But Peter, that's stuff and nonsense. Arbitrage is simply a transference between two or more markets. Net, net it does not add any new pressure to the process. It is a reactive procedure with a sum zero gain."

"Believe what you like," Peter responded with anger.

"Peter," I tried again, "I hate to break this to you, but arbitrage is no more the cause of a market decline than is the color pink. It is a practice as old as the market itself. In fact, index arbitrage is beneficial to the marketplace by adding liquidity and balancing out price differentials."

I was about to say more, but one look at Peter's face told me that this was not a subject to pursue. Things could get violent.

You see, Peter never forgot the lessons he learned as young man in the business. In the recesses of Peter's mind, his pink law of market dynamics lives on. He has simply replaced the color with index arbitrage. The principle is the same, its simplicity undeniable. After all, no sooner is there index arbitrage (as a consequence of "sell-programs"), then the stock market goes lower. (Actually the reverse is equally true as a consequence of "buy-programs," but Peter's logic doesn't bother with rising prices since they are always welcome and need no specific cause factor.)

In Peter's mind, index arbitrage has become the controlling element. To him, index arbitrage is no longer the messenger, the vehicle. Instead, it has assumed the substantive role. Index arbitrage, like the color pink, became the reason for the market's decline.

If you are still having difficulty comprehending Peter's logic or his pink law of market dynamics, allow me to make a modest suggestion. You will need to study the finer points of the marketplace. I suggest you begin with the story of "Chicken Little." Read it carefully and in no time you too will understand why the sky is falling.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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