Trust in markets is lost again

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The breathtaking plunge in stock prices Thursday was the latest in a series of blows that have shattered investor confidence in the financial engine that is Wall Street.

Devastated by the 2008 meltdown, retail investors were only just beginning to return to the stock market. This week's mess, however, threatens to undermine any nascent recovery in trust as investors question the integrity of the system and the credibility of the markets.

It's ironic given that the structural changes in the market, including new rules and the introduction of electronic trading over the past decade, were supposed to level the playing field for the little guy.

What was once upheld as the world's centre of wealth creation looks increasingly like a warren where anything can happen, and its tales leave investors in an unforgiving mood. Fundamentals don't seem to matter any more in a financial system that increasingly looks rigged and dangerous.

In 2008, most investors were shocked to hear about the widespread use of exotic financial instruments and the extent to which overleveraged financial institutions nearly brought the global economy to its knees.

What on earth did collateralized debt obligations tied to U.S. subprime mortgages have to do with your carefully tended retirement portfolio? The answer still isn't clear, but the damage is: Major North American indexes were cut in half.

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Then came the shocking allegations of what went on before this meltdown. In April, the U.S. Securities and Exchange Commission launched civil fraud charges against Goldman Sachs Group Inc., alleging that the financial firm sold a product without disclosing that a bearish hedge fund had helped create it.

And now this: A brutal stock market anomaly, possibly driven by nonsensical computerized selling, that sent the Dow on Thursday to its biggest intraday point dive ever.

To be sure, there were some fundamentals behind the sharp selloff. The debt crisis in Greece is growing increasingly worrisome, some central banks are beginning to tighten their monetary policies and stocks have had an incredible run over the past 14 months, leaving them vulnerable to a pullback.

But a 1,000-point decline by the Dow? Blue-chip stocks falling to a fraction of a penny? It's enough to make even sophisticated investors shake their heads.

Jeff Yale Rubin, director of research at Birinyi Associates, pointed out that structural changes in the stock market, including new rules and the introduction of electronic trading, over the past decade were supposed to level the playing field for little investors.

"Unfortunately, it has created more of a monster," he said. It helps explain why disgusted investors have been flocking into bonds during the past year, even as the stock market has been recovering.

It also explains why U.S. consumer sentiment has shown no indication of recovering to its heights of a decade ago.

"The pessimism that people have about the recovery, about the financial system, about feeling helpless - it has persisted throughout this comeback," said Marc Pado, U.S. market strategist at Cantor Fitzgerald.

This latest twist in the stock market can only hurt matters. The risk is that investors will become convinced that careful stock selection and buying for the long term are no match next to bigger, more powerful, more self-interested players - and that they will turn away.