Op-Ed

Making Big Investors Safe Means Raising The Risk For Others. The Surge Can’t Last; The Tree Doesn’t Grow To The Sky.

Martin Mayer

Markets can blast off like rockets, but they can’t reach escape velocity: What goes up, comes down; the tree doesn’t grow to the sky; the bigger they are, the harder they fall. That was then, of course, and this is now—but the maxims are still true. For the past two years, stock prices have been rising much more rapidly than corporate earnings, and that simply can’t continue.

Built into today’s stock prices is popular expectation that corporate earnings will be up by another 15% to 20% in 1997, with a repeat performance in 1998. But most analysts think that improvement in 1997 earnings will not rise that much, and 1998 may show no improvement at all. Rising wages will squeeze profits. A strong dollar will cut exports by making American products more expensive—and exports now account for 12% of our total output. The Federal Reserve, scared of the return of “stagflation,” rising prices and sluggish incomes, the worst of both worlds, will start pushing the interest rates up again, maybe as soon as next month.

Even if the Fed doesn’t move, others will. What has held down our long-term interest rates is steadily increasing foreign purchases of U.S. government debt. Foreign governments and central banks now hold more than $600 billion of U.S. Treasury paper, half again as much as the Federal Reserve itself, and foreign private investors hold another $400 billion plus. Not to mention the $250 billion of U.S. currency that is used or saved abroad ($100 bills are our most profitable export). There’s no way foreign appetite for our paper will stay as keen as it has been. We need foreign purchasers of our bonds to finance our gigantic trade deficit. As the Japanese and Europeans dig themselves out of their recent economic troubles, they will find more attractive investments at home and they will demand lower prices—higher interest rates—before they buy our paper.

In today’s market, rising interest rates clobber stock prices. Valuing stocks in the old days, investors simply asked how well this company and its industry were likely to do in the years ahead. But ever since mathematically inclined “finance economists” took over the investment business, the first question asked is the discount rate that should be applied to an anticipated earnings stream. The higher the interest rate, the less the value of the earnings, the lower the price of the stock. Asset allocation formulas tell the computers to move money from stocks to what have become higher-yielding bonds. Thus news that the economy is growing fast can depress stocks because it argues for higher interest rates, and news that the economy has hit a rough patch can lift the market because interest rates decline.

Interest rate changes also push prices around in the separate but interconnected markets for stock options and futures contracts. The interplay between these markets and the stock market provokes the mathematicians—the “quants”—to send out immense orders to buy and sell to take advantage of very small fluctuations in interest rates. This “program trading” can raise or lower stock prices at breathtaking speed.

What the quants promise their clients, however, is not a few bucks here and a few bucks there, but mathematical safety in a dangerous world. Making the big institutions safe necessarily means loading more risk on the other participants in the market. The tactic is “dynamic hedging,” and what it means is that when prices start down in the stock market, the institutions that hold the stocks sell related contracts in the options and futures markets. This selling pressure feeds back into the stock market to depress prices further, but the institutions are now protected; they have limited their losses. For those who don’t use dynamic hedging, it’s every man for himself: There’s no nonsense about women and children first in this business.

A market dominated by abstract calculations and computer-controlled orders will turn viciously on its participants, as the stock market did in October 1987. The placid flow of buy orders from the 401(k) plans will be submerged in floods of institutional selling as everybody tries to get out early. Indeed, that flow will reverse in a system where the mutual funds give their shareholders the right to shift at will, without charge, from stock funds to bond funds or money market funds. The higher the market goes, the larger the number of innocents who will be massacred.

At its current level, this market is doomed.

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