As Markets Gyrate Wildly, the ‘Message’ Is Debated

Economists, investment strategists and even individual investors count on the financial markets to send intelligible signals about the direction of the broader economy.

But what is the Dow Jones industrial average trying to say when it plunges nearly 300 points in a couple of hours, then rebounds to finish the day off less than 10 points--which is exactly what happened Thursday?

The same question might be asked of the recently mighty U.S. dollar, which lost a nearly unprecedented 15% of its value against the Japanese yen in a day and a half of chaotic trading before regaining some ground Thursday afternoon.

The jaw-dropping volatility in global stock, bond and currency markets in recent days, a worsening of the wild swings that have dominated markets since summer, has even veteran investors shaking their heads in awe.

“This is as wild and nutty as it gets,” said Stan Weinstein, editor and publisher of the Professional Tape Reader, a market newsletter in Hollywood, Fla. “The last few days have been awful.”

The deeper question--and worry--is whether this extreme volatility is the harbinger of a global economic recession in 1999, or just a relatively brief market phase that will pass without dragging the United States and Europe into the malaise now gripping Asia.

For policymakers and investors alike, there is something of a cause-versus-effect issue now: Are the markets signaling that deeper economic problems are brewing? Or will the markets’ swings precipitate economic problems that otherwise would not have developed?

While it’s well understood that the financial markets don’t necessarily mirror the real economy--not on a day-to-day basis, anyway--there is increasing worry that the fear and frenzy among traders will infect consumer and business confidence and do lasting economic damage.

Michel Camdessus, managing director of the International Monetary Fund, sounded flummoxed Thursday when he pronounced the dollar’s sudden plunge “inappropriate” and said it reflected investor irrationality.

To be sure, analysts can offer highly technical reasons for much of the volatility that has rocked Wall Street in recent days and weeks. And few of those reasons are rooted in the fundamentals of the real economy.

For one, so-called hedge funds, the once-obscure, highly secretive international investment funds for the well-heeled, are under sudden pressure to pay back huge loans they took out earlier this year to make wrong-headed bets on the direction of stocks, interest rates and currencies worldwide.

Those funds, which control tens of billions of dollars in “hot” money, now are dumping stocks, dollars, Treasury bonds, mortgage-backed bonds and other assets in a panic rush to raise cash, pay off their loans and close out their bets.

At the same time, opportunistic speculators are trying to surf the wave created by the hedge funds. In a practice known as “front running,” they try to guess what the hedge funds will be selling and sell the same things themselves, before the hedge funds dump. This is magnifying the markets’ price moves.

Meanwhile, more cautious investors are just trying to get out of the way, and their lack of bidding--at least until a market appears to be turning, as U.S. stocks did later Thursday--also can exacerbate the volatility.

Federal Reserve Board Chairman Alan Greenspan put his finger on it in a speech Wednesday, noting that he had never seen such a rapid shrinking back by investors from risk of all types.

Greenspan said a “fear-induced psychological response” was causing investors to disengage from the markets, “basically saying: ‘I want out. I don’t want to know anything about whether a particular investment is [truly] risky or not.’ ”

When investors disengage in a big way, financial asset prices can go into free falls.

One technical barometer of fear is an index that measures the volatility of the market for stock options--not the kinds that companies distribute to employees, but publicly traded “derivative” securities that allow investors and traders to make bets on, or hedge against, major moves in individual stocks, with little money down.

That index now is at its highest level since the stock market crash of October 1987. Many investors are using options to protect themselves against a further drop in the stocks they own. The rising index means, in part, that the price of such insurance in skyrocketing.

But what is harder to say is how long this process will go on and what impact the technical business of unwinding risky investments ultimately will have on the real economy.

“No one can really get a handle on the magnitude of this,” said Allen Sinai, chief economist for Primark Decision Economics.

One problem is that many of the institutions lending to hedge funds and other speculators are not banks and so do not have to report their exposure to financial regulators.

That leaves the regulators, such as the Fed, in the dark about the severity of the problem.

Fundamentally, one worry is growing: As commercial banks and other lenders try to rein in their risk of loan losses amid the current trading chaos, there is a global credit crunch developing, Sinai said. For now, the crunch is mainly affecting financial markets--that is, it is getting harder to borrow money to buy stock, for example.

But eventually, the credit crunch could affect companies that want to borrow money to invest in their businesses, Sinai said. Already, less credit-worthy borrowers are getting squeezed as investors spurn their bonds. And many of today’s riskiest corporate borrowers are potentially tomorrow’s biggest growth companies, Sinai noted.

He said he expects the credit crunch to significantly slow the U.S. economy next year, but probably not enough to induce a recession.

Even so, optimists note that despite the stock market’s crash in October 1987--culminating in a 36% plunge in the Dow index from its summer peak that year to its October low--the U.S. economy continued to boom in 1988.

So far this year, the Dow has lost 17% from its peak, although many stocks are down much more.

Still, Greenspan himself has acknowledged that the financial fears can threaten the real economy. Some analysts took his Wednesday speech as a sign that the Fed again will ease short-term interest rates, as it did last week.

The timing is delicate, however. If the Fed decided to take immediate action rather than wait for its next regular meeting, the markets could take it as a sign of panic.

“Instead of, ‘Oh, good, they’re lowering rates,’ the reaction could be, ‘Omigod, what do they know?’ ” said economist John Ryding of Bear Stearns & Co.

Still, Ryding criticized central bankers for not being more forceful in the current crisis. He said that now is a time for them to get together and take coordinated action to calm fears.

“Central bankers like to give you the sense that they’re in charge, but most times they’re not willing to make the sacrifice required to actually make the markets do what they want,” said Robert Brusca, chief economist of Nikko Securities.