Finding Your Way on ‘the Street’
Wall Street’s Crash of 1987 has given the public a graphic view of the stock market, with television footage of harried traders in New York, Los Angeles, Chicago and elsewhere. Here’s a primer on how the market works, where it originated, why it exists, why it matters and other basic questions:
Q: Why should I care about the stock market if I don’t own any stocks? A: Many people are affected by the price movement of stocks without realizing it. Your insurance premiums may be affected by your insurance company’s gains or losses from its large stock portfolio, for example. Many more people than in the past now are members of stock ownership plans sponsored by their employers. These plans have gained great popularity since 1982, when the bull market began. Brokerages have also attracted into the stock market billions of dollars of money in individual retirement accounts, or IRAs, often through mutual funds that own stocks on behalf of their customers. So the assets of millions of Americans are tied up in the stock market.
Moreover, the level of the stock market can affect the decisions that individuals and companies make about their own spending. Following Monday’s crash, many individuals may defer their spending on homes, cars, even Christmas presents. So home builders, auto manufacturers and department stores may suffer, perhaps laying off employees, restricting raises and putting off investments in new factories and the543387502In this way, the impact of the market ripples through the entire economy.
Q: Is there only one stock market? A: In this country, there are actually three major stock markets and several regional stock markets. The largest is the New York Stock Exchange, at Wall and Broad streets in Manhattan, where the stocks of about 1,575 U.S. and foreign corporations are traded. The dollar value of these trades reached a record $1.4 trillion last year. This year, it is certain to be even higher.
Stocks of smaller companies are traded a few blocks away at the American Stock Exchange. And stocks of even smaller enterprises are traded in what is known as the over-the-counter market operated by the National Assn. of Securities Dealers. Unlike the NYSE and the Amex, the over-the-counter market is not run out of a single building where brokers meet to arrange stock trades. Instead, trades are arranged over a telephone network connecting thousands of individual stockbrokers.
Stocks are also traded on the Pacific Stock Exchange, with operations in Los Angeles and San Francisco, and on the Boston and Philadelphia stock exchanges. These markets function like the New York and American exchanges--in fact trading many of the same stocks--but they are much smaller.
Q: How did the New York Stock Exchange begin? A: In 1792, a small group of brokers began to meet regularly by a buttonwood tree on Wall Street, arranging trades of stock in the country’s fledgling businesses. That May, the brokers organized themselves into a guild that would become the New York Stock Exchange. The 24 individuals and partnerships that signed the so-called Buttonwood Agreement established a
fixed rate of commissions and a system of giving each other preference in their trading. Since then, the exclusivity of the exchange has often been challenged and its franchise eroded (fixed commissions were outlawed in 1975), but it remains the most powerful trading organization in the finance world.
Q: What does a share of stock actually represent? A: Theoretically, a stockholder owns a portion of a company’s equity, or that part of the company’s net worth not pledged to banks and other lenders. Generally, this gives the shareholder a right to a piece of any company profits, a portion of which may be distributed to holders every three months in the form of dividends, most often in cash. Because annual dividends customarily amount to only a tiny percentage of the purchase price of the stock, most stockholders really expect to make more money by a rise in value of the stock on the exchange. This is known as a “capital gain.” The expectations of millions of stockholders that these gains would indefinitely continue their rise of the last five years were dashed by Monday’s crash.
Q: What determines a stock’s price or value? A: The price of a company’s stock is based on the most recent trade of each of its shares on an exchange; the price of each trade is immediately transmitted to the exchange’s computers for moment-by-moment updates. Thus, if you bought a share of IBM for $120 several months ago, its current price may be only $105 because that is the level at which a block of its shares was purchased earlier Thursday. In the same way, if you bought your house for $80,000 three years ago, its price now might be affected by the $100,000 your next-door neighbor got for an identical home last week.
The share’s real “value” might be very different from its price, however. Stocks rise and fall on investors’ expectations about companies’ future profits. Different investors may have different ideas about how fundamental conditions of the company--its prospects for profits, its chances of winning or losing a court case, the likelihood that it will be taken over--should be reflected in that price.
Q: Why does a company issue stock? A: This is one way corporations raise money from the public. A company has two basic choices: It can issue bonds, in which case it is borrowing money from the bond buyers at a fixed or variable interest rate that it must continue to pay regardless of whether its profits cover the cost, or common stocks, for which there is no fixed payment. That is why stock dividends can fluctuate with the rise and fall of profits. There are also preferred stocks, a hybrid of bonds and common stocks.
The company gets money when it first issues its stock, but gains nothing more directly when the shares are subsequently traded among investors. Companies remain intensely interested in their share prices for several reasons, however. For one thing, if the shares become cheap, they can more easily be purchased by someone intent on accumulating enough to own the whole company--a takeover. In addition, a company planning to raise more money by issuing more stock wants its existing shares to trade at a high price so investors will pay more for the newly issued shares. Executives are also keenly interested in the value of shares because, in addition to their salaries, many are compensated with stock options. These options give the executives the right to buy their companies’ stock at a discount, under certain conditions. They may also receive stock outright as bonuses.
Q: What does the Dow Jones industrial average have to do with the price of these stocks? A: As its name implies, the Dow is a measure of the prices of 30 leading stocks, recomputed instantaneously as the price of each component stock changes. These stocks include American Express, Eastman Kodak, IBM, McDonald’s and Exxon. The average was created at the turn of the century by Charles Dow, whose corporate descendants at Dow Jones & Co. publish the Wall Street Journal. Stocks included in the Dow average have changed many times over the years; the Dow was originally only 12 stocks.
As an indicator of the prices of only 30 of the common 1,500 stocks traded on the New York Stock Exchange, the Dow average does not always reflect the movement of the stock market as a whole. As recently as Tuesday, the Dow moved up sharply while the prices of stocks on the American exchange and the over-the-counter market continued their slide.
But as the most familiar market index, the Dow is widely treated by the public as interchangeable with the stock market. Among other widely followed stock indexes is the Standard & Poor’s 500, a measure of the market value of 500 stocks heavily held by professional investors.
Q: How is a trade carried out on the New York Stock Exchange? A: This is where all those people milling around in the chaos of the exchange floor come in.
The people on the floor fall into several distinct groups. The most numerous are floor brokers, who carry the buy and sell orders of brokerage clients. Each broker with a buy order is on the prowl for a broker with a corresponding sell order, and vice versa.
The most important group are the “specialists.” These are brokers, often working for family firms passed down from generation to generation, who under exchange rules supervise what amounts to an auction in a number of stocks. A single specialist firm might be responsible for 30 or more stocks. The specialist stands at a permanent post--the large circular counters set about the floor and bedecked with ranks of television screens. His job is to ensure that floor brokers find their match and that every such trade in his assigned stocks is reported to the exchange and its price quoted publicly on the video screens hanging from the post.
Moreover, the specialist is charged with maintaining an orderly market in each of his stocks. In practice, he is supposed to ensure that the price of the stock moves in steps of no more than an eighth or quarter of a dollar at a time, so that sudden, sharp price changes do not create unfair advantages for certain investors. He does this by buying shares when sell orders prevail and selling when most others are buying.
In a normal market, the specialist can make enormous profits on the routine eighth- and quarter-point price moves. In an exceptionally heavy market like Monday’s, in which stocks head straight down, the specialists can take a beating. One crippled firm has already been taken over by Merrill Lynch.
Q: What is the “ticker” and what is the “tape?” A: The ticker--which once referred to machines that printed each stock trade on a narrow strip of paper known as ticker tape--now generally refers to the service that prints on-the-spot financial information during the market day and that is operated by Dow Jones & Co.
Meanwhile, the old stock tickers have been replaced by continuous electronic reports visible in most brokerage branches and on the floor of the New York Stock Exchange. This is generally known as the “tape.” Because the tape’s capacity for displaying information at a pace that people can read has been outrun by the ferocious trading pace of the last week, it has been as much as two hours late in displaying most recent stock prices.
Q: What about program trading? A: As the financial markets have made their quantum jump in size and sophistication during the 1980s, big institutional investors such as insurance companies, pension funds and so on have begun using computers to place massive orders in the blink of an eye. These are program trades. Most often, they involve an investment parlay between a group of stocks representative of the Dow Jones or S&P; 500 index, and corresponding futures contracts traded on commodity exchanges in Chicago.
These futures are investment contracts that give the buyer the obligation to deliver the value of the underlying stocks at a given price at a set point in the future. The buyer need not own the stocks themselves.
The price of the futures trace the theoretical price movement of the representative stocks--but not exactly. A program trader tries to take advantage of the tiny price discrepancies between the future and the stocks in this way: When the future price slips below the price of the stocks, he buys the future and sells the stocks, taking as profit the price differential.
Who would sell the future to the program trader? The futures markets are kept alive by professional speculators who are in effect making opposite bets from the program traders on the direction of stock prices. If program traders are selling, speculators will buy. If program traders are buying, speculators will sell. Non-professionals can also trade in this market, but it is exceptionally risky, even for the most well-heeled and well-informed investors.
The scale of this trading has far outstripped traditional stock trading volume, placing a huge strain on the stock exchanges’ ability to manage it. The result has been devastating price swings in the stock markets during the past couple of years. Monday’s 508-point drop in the Dow now stands as the prime example of this volatility.
Q: Do these things serve any purpose? A: Theoretically, they are valuable to use as a “hedge,” or a form of insurance against bothersome movements in stock prices. A big pension fund wishing to sell $10 million in stocks because it believes the market will head generally down might not want to sell all those shares at once, for fear of depressing the market prices even more sharply. To protect against a market slump in the meantime, the fund could sell stock-index futures worth about $10 million, as a surrogate for selling the shares themselves. This process locks in a price for the fund’s stock while it goes about selling its holdings in a more gradual manner. Proponents say this practice is good for the stock market, because a pension fund fearing itself unprotected in a market slump would never have bought stocks in the first place.
Still, financiers have been debating for years whether these exotic but widely used contracts add anything to the economy or are simply a new way of moving money around unproductively.
