Dow Jones Vulnerable to Another Flash Crash

Stock market activity is still dominated by high-frequency trading and concentrated around just a few stocks and exchange-traded funds, creating an environment that will likely lead to another ‘Flash Crash’.

"Markets that are not built on fundamental demand from long term investors are subject to cracks like we saw on May 6th," said Joseph Saluzzi, co-head of the trading desk at Themis Trading, an agency brokerage firm. "When shocks like sovereign debt problems hit the market, the lack of real demand is exposed and a market which is not structurally sound can produce violent reactions."

Saluzzi was featured last month in a 60 Minutes episode exploring the dangers of high frequency trading. This summer after the Flash Crash, his partner, Sal Arnuk, was asked to participate in an open meeting with the Securities Exchange Commission on market structure. They are some of the few electronic trading experts willing to talk about the practice because they guide clients around high-frequency trading instead of practice it themselves.

The firm’s renewed prediction today for another violent sell-off is based on a simple breakdown in the market basics of supply and demand.

"Prices set by the stock market are thought to be efficient and reflect an accurate measure of supply and demand," wrote Saluzzi in the note. "But can we trust a market where most of the volume is concentrated in just a few stocks?"

On Thursday, General Motors, Citigroup and Ford accounted for 15 percent of the shares traded, according to Themis. This kind of concentration does not occur in a market operating under the basic economic function of supply meeting demand, they argue. How could 15 percent of actual investors want to buy or sell these three stocks in a single day?

They also cite the volume in ETFs, baskets of whole stocks that can be bought and sold as easily as a single share. Trading in the SPDR S&P 500 (SPY), PowerShares QQQ Trust (QQQQ) and iShares MSCI Emerging Markets (EEM) are typically among the most activiely traded vehicles on U.S. exchanges every day. Many individual investors have taken to these products in order to avoid single-company risk.

The regular long-term investor, who doesn’t buy or sell in milliseconds, is essentially gone from the market, Themis said. According to ICI data, there have been 28 consecutive weeks of domestic equity outflows since the May intraday crash where the Dow lost nearly 1,000 points in minutes. Turnover is now so great that the average holding period for stocks is just three months, according to Alan Newman’s Crosscurrents newsletter.

To be sure, stocks have recovered the losses from the May crash and then some, hitting a new high for the year just earlier this month. Some argue that the long-term investor is coming back soon and will add another leg to this bull market.

Maybe they decided to begin by buying GM, Ford and Citigroup yesterday.

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Ref: http://www.cnbc.com/id/40274710

John Melloy is the Executive Producer of Fast Money. Before joining CNBC, he was an editor for Bloomberg News, overseeing the U.S. Stock Market coverage team