Low Stability Makes Market Roller Coaster

People are always wondering why the stock market does what it does. Newspapers run stories daily purporting to explain why, but they don’t do it very convincingly. That’s mostly because the expert market watchers seldom are willing to say simply, “I don’t know.”

That would be a good answer, because if the market moved in a rational, totally explainable manner, there would be no gamble to it. Still, when stocks do something dramatic, as they did last week, folks want to know what’s going on.

Part of the answer they got last week would have sounded almost funny, except that a record 39-point one-day drop in the Dow Jones average is too disconcerting for much laughter. Another part of the answer was quite logical. A third part was too technical for most people to understand. A fourth part involved a basic change in the market not usually mentioned.

What the experts said triggered it all was a decline in the U.S. unemployment rate. That’s good news, right? Well, yes and no.

One of the well-known economic pundits translated those bullish unemployment numbers into a prediction about the Federal Reserve Board. Henry Kaufman, chief economist for Salomon Bros., said that with the economy obviously improving, the Fed would see less need to knock interest rates down. So suddenly good news became bad news. Higher interest rates generally spell bad news for the economy.

It’s kind of a thin reed on which to base a record plunge in stock prices.

In truth, however, while Kaufman has sparked many a temporary change in the market’s direction, investors probably were just looking for an excuse, the experts went on to explain. After all, what goes up has to come down sometime, and the faster the market moves up, the sharper the correction (“correction” is a nice way of saying “falling prices”). Investors decide to sell in order to realize some of the profit they’ve made on paper.

No One Predicted Decline

The problem with that explanation is that until last week, most experts were saying the market would probably go higher, based on an improving economy and relatively low inflation. While some expected a correction, no one mentioned anything as dramatic as Wednesday’s decline.

So why suddenly a 39-point drop?

The experts pointed to some new investment strategies engaged in by sophisticated traders. They involve devices called index futures for gambling on future stock price swings, or protecting against them. At one point last week, it was easy to make money simply by selling stocks and buying futures.

That’s still not a total explanation, however. Part of the blame lies with a structural change in the market. More and more of the trading is being done on behalf of huge portfolios of stock investments--mutual funds and corporate or union pension trusts.

It is, of course, axiomatic that people who run these huge investment funds understand the market better than the rest of us.

So why don’t they make the market a more rational place?

Because they have a problem. There aren’t that many of them. They tend to look at the same bits and pieces of information. And when they see what looks like a turn in the market, they can’t afford to be left behind. Hence, a small selling wave gets bigger, much bigger than what the market used to experience.

It all adds up to a professional’s market, which doesn’t bode well for market stability. Institutional investors now account for well more than half of trading in stocks listed on the New York Stock Exchange. Something like 60% to 70% of pension fund holdings change every year. And 50% of the money in those funds is invested in only 200 prominent companies.

It’s not that the professionals are manipulating. It is that the market has lost some of the stability that comes from having stocks much more broadly distributed and buying and selling decisions far more varied. That breadth would tend to moderate short-term price swings.

The unfortunate side of events like last week’s is that it probably discourages some amateurs from getting involved in the market, and that leaves the market to become even more dominated by a few.