Manic Market

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Never in U.S. financial history has there been a collection of commotions quite like the Great Stock Market Spectacular of 1986. Up! Up! Up! Down! Down! Down! The Dow Jones average of industrial stocks is taking sharper, swifter leaps and dives than ever before. Buy! Buy! Buy! Sell! Sell! Sell! The biggest stock boom on record is leading to manic levels of activity on the nation's exchanges. Win! Win! Win! Millions, even billions, are being pocketed almost overnight, in split-second transactions affecting the fate of some of America's most important corporations. Lose! Lose! Lose! At the same time, Wall Street is struggling to recover in the public eye from some of the worst insider-trading scandals in its history.

But much more than mere pandemonium is taking place. Behind the unusual eruption of financial sound and fury, an electronic upheaval is sweeping Wall Street, drastically reshaping the way stocks are traded and business is performed in the U.S. and around the world. At the center is a wave of computerization that has radically changed the speed of stock trading and injected unprecedented floods of money into the marketplace. For those with the cash or credit, the equipment and the expertise to play in the new market, the times seem utopian. One Manhattan-based private investor who is viewed with awe on Wall Street for his financial acumen is claiming that the U.S. and the world are on the "threshold of a new golden age of capitalism."

To others, the whirlwind of activity seems more like a new variation on Mark Twain's Gilded Age, a time of reckless speculation and profiteering. Amid the hubbub of buying and selling, a host of probing questions are being asked about the stock market and its relationship to U.S. capitalism in general. Has the market become more volatile, risky and perhaps more irrational than ever before? Is it suddenly too treacherous for the ordinary investor? Is the very function of the market changing, as fast-buck artists crowd in to pursue big quick returns that have little or nothing to do with industry or commerce? Have the values of the gambling hall undermined the role of stock trading as a means of productive, long-term investment? In short: Is the new stock market good for America, and for business?

Many of those questions have been asked before. In 1936 Economist John Maynard Keynes warned that "when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill- done." His comments were a reminder of the speculative frenzy of the Roaring Twenties, which led, soon enough, to the Great Crash of Oct. 28, 1929. Last week, as the 57th anniversary of that dire event rolled around, new voices raised similar cautions. Said Robert Reich, a lecturer in public policy at Harvard's John F. Kennedy School of Government: "In America, industry has become the plaything of finance." Banker Felix Rohatyn, a partner in the Manhattan investment firm of Lazard Freres and a frequent critic of Wall Street's excesses, goes further. Says he: "Now the whole world is a casino. Las Vegas, at least, closes at 5 a.m. This thing does not."

Certainly, the market's behavior all year has been enough to keep almost anyone wide awake. After reaching what some analysts felt were the final stages of a bull market that began in 1982, the Dow exploded from 1502 in January of this year to 1856 in April, the biggest three-month gain in history. Then the market suddenly went into fibrillation. The Dow dropped a bearish 46 points one day (June 9) and 62 another (July 7). The bulls came back with a rush on Sept. 4, when the Dow reached a new all-time high of 1920. But on Sept. 11 and 12, in a frenzied wave of selling, the Dow slid 121 points, including a one-day drop of 87, the worst ever. Since then, the indicator has continued to jounce at unpredictable intervals in 20- and 30- point jumps and dips, closing last week at 1878, the same level that it had reached in May.

The result of all that unpredictability has been a bull market in benchmarks. No fewer than seven of the ten worst one-day declines in stock- market history, measured in terms of drops in the Dow, have taken place in the past ten months. So have five of the ten best single-day tallies ever recorded.

Those Himalayan highs and lows have spawned reflexive worries about a possible major stock-market crash, a la 1929. That is unlikely. Professional analysts are quick to point out that in percentage terms, the ups and downs of the Dow and other stock-market indicators are much less frightening than they appear. The Sept. 11 decline, for example, amounted to a 4.6% drop in a Dow Jones average of 1879.5. By contrast, on Oct. 28, 1929, the Dow fell 12.8%, or 38.3 points, to 260.64. Argues Henry Van der Eb, president of the Chicago- based Mathers investment firm: "The market isn't any more risky than it was. But it's more nerve-racking."

Whether or not risks have been heightened, the computerization of stock trading has made the market more responsive than ever to the freewheeling instincts of a powerful breed of institutional investors. They are the portfolio managers of huge pension, insurance and mutual funds, along with private investment groups and the equity-trading departments of major brokerages and banks. In all, U.S. institutions have an estimated $950 billion in stocks and gigantic batteries of electronic brains at their disposal. At the touch of a button, or the press of a panel on a touch-sensitive computer screen, the trading behemoths regularly send hundreds of millions of dollars cascading in and out of the markets, affecting the value of hundreds of stocks simultaneously. Even though they control only about 33% of the equity on U.S. exchanges, institutional investors currently make about eight out of every ten stock trades each day.

The frantic activity of these pachyderms has led to the biggest surge in trading volume in stock-market history. The major focus for the explosion is the New York Stock Exchange's Big Board, where 1,523 stocks worth an estimated $2.1 trillion are listed. Only a decade ago, 30 million shares changing hands daily would stretch the capacity of the New York exchange to the limit, leading to hours of delays in completing transactions. This year the volume has skyrocketed to an average of about 140 million. During September's record sell-off, an unprecedented 240.5 million shares changed hands during a single day.

The overwhelming wave of trading has spilled over to other exchanges. For the first nine months of 1986, volume on the American Stock Exchange soared to 2.3 billion shares, 53% higher than the same period a year ago. In Chicago, Midwest Stock Exchange Chairman John Weithers exults that "in the past year we did more volume than we did in the past 92 years combined." Trading volume on the Pacific Stock Exchange surged 35% in the first three quarters of the year, compared with the same period in 1985.

One of the chief beneficiaries of the computer-driven boom is the over-the- counter market known as NASDAQ (for National Association of Securities Dealers Automated Quotations). Founded in 1971, NASDAQ does not own a trading floor. Instead, the system offers computerized listings of 4,444 mainly small- and medium-size corporations (worth: about $300 billion) whose shares can be bought and sold on 2,100 terminals nationwide. This year NASDAQ's daily average trading volume of more than 100 million shares made it the world's third largest exchange, after New York City's Big Board and the Tokyo Stock Exchange.

Trading profits have also been phenomenal. Among the most successful institutional investors, it is not uncommon to find annual growth rates in assets of 20% or more. On portfolios of $1 billion or so, even a fraction of a percentage in commission means millions in income. Dean LeBaron, the sole owner of a highly automated Boston-based investment firm known as Batterymarch Financial Management, manages pension funds worth between $11 billion and $12 billion. LeBaron's personal income fluctuates at around $30 million yearly. George Soros, a Hungarian-born, Manhattan-based investor who manages a private fund named Quantum, has seen the value of those assets jump from $449 million to $1.5 billion in one year. Soros' personal profit for the past twelve months is an estimated $180 million.

What distinguishes the new institutional investors from other kinds of stockholders, however, is their lack of interest in almost all aspects of corporate performance except stock price. Indeed, many of the institutions, such as pension funds and mutuals, are virtually constrained from thinking of anything else in their role as trustees for smaller investors. According to critics, one result has been that the U.S. investment community's already legendary focus on quarter-by-quarter corporate economic performance has become more pronounced than ever.

Management Expert Peter Drucker has used the term speculator's capitalism to describe the institutional loyalty to short-term profit that he believes is now the market's driving force. As a result of that impetus, Drucker wrote recently in the Wall Street Journal, "corporate managements are being pushed into subordinating everything (even such long-range considerations as a company's market standing, its technology, indeed, its basic wealth-producing capacity) to immediate earnings and next week's stock price." In Drucker's view, that attitude stands in contrast to the practices of such U.S. competitors as the West Germans and the Japanese, whom he lauds for having the attitude that business is a "wealth-producing, goods-producing, jobs- producing entity."

The penalty for U.S. managers who choose to ignore the stock market's short- term imperative, though, is evident in Wall Street's takeover frenzy. Some 2,500 mergers and buyouts, worth more than $118 billion, have taken place so far this year, up from 2,463 deals worth $96 billion during the comparable period a year ago. As corporate raiders are well aware, institutional investors are more prone than other kinds of shareholders to sell during a raid, in order to gain a quick profit. They are also readier to hear arguments that focus on the value of corporations when broken into component assets rather than on their worth as ongoing enterprises. A poignant rendition of the managerial plight comes from Andrew Sigler, chairman of Stamford, Conn.-based Champion International, a $5 billion wood-products firm. Some 80% of Champion's stock is now held by institutions, Sigler believes. Says he: "The owners of our stocks come and go within hours. There is no one out there anymore who cares about our company as an institution. It's put tremendous pressure on short-term earnings. I'm helpless as a manager."

The predatory trends that have surfaced in the hit-and-run stock market have tended to feed on themselves. One sign of that is the phenomenal growth of the so-called junk-bond market, a $100 billion pool of high-risk, high- interest securities that have backed such takeover bids as Atlanta Broadcaster Ted Turner's $5 billion failed attempt to buy out CBS and Carl Icahn's successful $300 million takeover of TWA. The creation of such huge war chests for the use of takeover artists, among others, has heightened merger activity.

One by-product of the acquisition binge has been a surge in insider trading. Only in recent weeks has Wall Street begun to recover from its worst- ever scandal, when last spring Dennis Levine, a managing director of the Drexel Burnham Lambert investment firm, admitted to using insider tips on takeover bids to trade in the shares of 54 companies. According to the Securities and Exchange Commission, the deals earned him $12.6 million in illegal profits. Levine pleaded guilty to four criminal counts and awaits sentencing. Eventually, four other Wall Streeters were tainted in the same scandal.

The atmosphere of near panic that gripped insiders at the height of the investigation has subsided, but the probe seems to be having lasting effects. Surveys have shown a definite slowdown in the trading of stock of major corporate takeover targets immediately before the announcement of merger bids.

A more bewildering development is the array of complex, computer-assisted trading techniques that, in taking the stock exchanges by storm, have become a major cause of the market's extraordinary peaks and valleys. The most controversial is known as program trading, in which computers, for example, launch massive buy and sell orders for stocks and stock-index futures simultaneously (see following story).

The volume of shares involved in the wild cycles of program trading -- lots of more than 500,000 at a time for each trader are common -- has become the "tail that wags the dog," says Manhattan Investment Manager Soros. Observes Louis Holland, a partner in the Chicago investment firm of Hahn Holland & Grossman: "The little guy in the street is very concerned about all this perceived volatility. He doesn't think he has a chance."

Undeniably, individual investors, who still own $1.95 trillion in equities, or two-thirds of all U.S. stock, have been getting rid of their holdings at a swift clip. In 1985 U.S. households sold $122 billion more in stock than they bought, a record. This year the net sales are projected to reach $105 billion.

But this does not necessarily mean that individuals are getting out of the stock market entirely. Instead, increasing numbers of Americans are returning as institutional investors themselves, in the form of shareholders in mutual funds. Nearly half of the 47 million U.S. households that own stock now do so through mutuals. In the past two years alone, the number of mutual-fund shareholders increased by 2.7 million. Says James Van Horne, a professor of finance at the Stanford University Business School: "Individuals increasingly are becoming indirect stock owners." One of them is Bill Blankemeier, 31, a regional sales manager for ITT in Oak Brook, Ill. Blankemeier moved 70% of his portfolio into mutual stock funds after taking a mild beating on several of his own stock picks. Says he: "Half the time, I'd do O.K., and half the time I'd blow it. I'd rather have someone invest for me who has the time and the expertise."

There is considerable irony in the retreat by individuals. Virtually all of the stock market's current volatility has been made possible by computers. And these in turn were originally installed at New York's Big Board to offer easier, cheaper trading to tempt back small investors who had begun to flee to bonds and money-market accounts during the high-inflation '70s. In all, the Big Board spent $200 million on its modernization during the past five years. When the stock market perked up again starting in the early 1980s, the major institutional investors quickly spotted the advantages of scale and sophistication offered by electronics. Says Richard Nelson, a vice president with Manhattan's Bankers Trust: "Ten years ago, you simply could not sell or buy more than 20 or 30 stocks at the same time. Now we routinely sell multiples of 500."

Much of the capacity to do that is invisible behind the traditional pillared facade of the New York Stock Exchange. There is still plenty of human hubbub on the trading floor, but less than there used to be in the pre- electronic '60s. Glowing cathode-ray screens now festoon the marble columns of the venerable hall. Overhead, gold-painted tubes conceal telephone and computer cables. Some 450 specialists stand guard at 14 trading posts, a few more than in older days, matching buy and sell orders from stockbrokers.

In the bowels of the exchange, and scattered around the remainder of New York City and its environs, are the banks of IBM and Tandem computers that run both the Big Board's SuperDot (for designated order turnaround) system and the equivalent operation for the American Exchange, which is known as PER (postexecution reporting). These systems record trades and relay confirmation back to brokers. Officials from both exchanges maintain rigid secrecy about the computers, which are owned and operated by a joint affiliate known as the Securities Industry Automation Corp. It is said, however, that S.I.A.C.'s number-crunching capability rivals that of NASA's Mission Control.

Six miles of fiber-optic and coaxial cables run through the S.I.A.C. complex, which communicates with equally impressive banks of machines at major brokerage houses, as well as with tens of thousands of personal computers, passive desktop terminals, printers and other devices. S.I.A.C. relays information to at least 500 display terminals on the N.Y.S.E. trading floor alone. The exchange computers communicate in five different computer languages, manage almost 1,000 orders a second, and can handle a trading volume of 450 million shares daily, nearly twice the current record.

The major brokerage houses, which are particularly eager to serve customers that deal in large orders of anywhere from 100,000 to 1 million shares, have ultrapowerful computer complexes of their own. At the lower Manhattan trading floor of giant Merrill Lynch, which handled $184 billion worth of securities last year, batteries of IBM computers and a pair of Amdahl supercomputers have been installed to ensure that stock trades take no more than 15 to 20 seconds.

The most eerily advanced computerized operation of all may be nestled away on the twelfth floor of Boston's modernistic concrete-and-glass Federal Reserve Building, headquarters of the Batterymarch Financial Management investment firm. Owner Dean LeBaron has designed his own programs for a brace of Prime mainframe computers that daily spit out a list of several hundred sale or purchase contracts, usually for stocks in batches of 5,000 or 10,000 shares. The list is composed by the computers themselves, based on their general instructions of what and when to buy and sell. Up to 23 specially authorized brokers negotiate with the machines as they trade according to their preprogrammed instructions. Always aware of the latest stock quotations, the computers adjust their own prices accordingly. On average, Batterymarch pays only 2 cents to 3 cents in brokers' commissions per traded share, less than half as much as other major fund managers.

That kind of fast-as-light trading has made immediate information a vital concern. On his morning drive to his office in Manhattan's midtown General ! Motors Building, Howard Stein, chairman of the $35 billion Dreyfus group of mutual funds, stays in minute-by-minute touch with price moves of 72 selected stocks on a QuoTrex sideband FM receiver. The QuoTrex system uses the Security Industry Association's computerized data base, to which all U.S. exchanges report via the Intermarket Trading System.

Increasingly, the big movers and shakers direct their funds not only in and out of U.S. stock markets but abroad. Last year Americans bought additional foreign shares worth $12.8 billion, bringing their total overseas stock ownership to some $41 billion. The number of U.S. mutual funds devoted exclusively to foreign equities has nearly doubled in the past two years, to 43. Foreigners, on the other hand, bought $30.2 billion worth of U.S. stocks last year, bringing their holdings to $126 billion. By last June that total had climbed again, to more than $139 billion.

Some of the major institutional investors scour the world for stock bargains. One who has been roundly rewarded at that game is Peter Lynch, the aggressive manager of the wildly successful Fidelity Magellan Fund (assets: $7 billion), which last year notched up 43.1% growth. Lynch is widely known for his willingness to pick a foreign concern as an investment as readily as a domestic firm. He casts afield to West Germany, the Netherlands and even Finland for his choices.

To meet growing demand, electronic trading networks are reaching out internationally, in the first stages of what NASDAQ President Gordon Macklin calls a "global market for equities." That integration took a significant step forward in London last week. With much popping of champagne corks, exploding of fireworks and high jinks on the trading floor, the British financial community hailed the advent of Big Bang: the Oct. 27 abolition of a regime of fixed brokerage fees in existence since 1908, and their replacement by competitive commissions.

The British reform, which brought the London exchange into line with practices on Wall Street, will boost Britain's competitive position as an international equities-trading center. Big Bang also inaugurated an era of enhanced computer trading on the London Stock Exchange, where a new $21 million automatic stock-quotation system, known as SEAQ, went into operation. The Big Bang welcome was moderately dampened when trading on the London exchange was delayed for 65 minutes at the start. The reason: a computerized stock-quotation system crashed.

Another door has opened cautiously on the Tokyo Stock Exchange, where 1,492 Japanese equities worth an estimated $1.8 trillion are listed. Last January six foreign firms, including the U.S. investment houses of Merrill Lynch, Morgan Stanley and Goldman, Sachs, were invited to join the 83-member exchange. Now at the end of the trading day in Tokyo, giant Merrill Lynch routinely passes on an electronic "book" (accumulated position) of some 430 internationally traded stocks to its offices in London and then New York for further action.

But as the range and scope of electronic trading increases, so may the regulatory headaches. Says Gary Lynch, the Securities and Exchange Commission's enforcement chief: "The internationalization of the markets is a huge potential problem unless regulators are prepared to cooperate." Since May, the SEC and U.S. commodity-exchange regulators have signed memorandums of understanding with Japan and Britain, agreeing to share information in trading-fraud cases.

The question of what to do about the alleged excesses of the domestic stock market is considerably thornier. Many people argue that there is little or nothing to be done at all. That feeling is particularly strong within the Reagan Administration, which has a fervent belief in what the President calls the "magic of the marketplace."

Nonetheless, many members of Congress think that a fine-tuning of Government regulations is needed to keep the new financial buccaneers from running amuck. High on the wish list is some way to slow down the takeover mania afflicting corporate America. In the past two years, the House Subcommittee on Telecommunications, Consumer Protection and Finance, headed by Democratic Representative Timothy Wirth of Colorado, has held ten hearings on the subject. No simple solutions were found, however. Said one subcommittee staffer: "It's an area where the more you know, the less you want to legislate." Some 64 antitakeover bills were introduced in the House during the past session of Congress, but none were adopted.

In large measure, those who disagree with the idea of intervening in the marketplace to block takeovers seem to agree with James Cloonan, president and founder of the 105,000-member American Association of Individual Investors, a Chicago-based group. Says Cloonan: "An acquisition is the final defense of a stockholder who is being shafted by lousy management. The only way you can get your money out and be saved is if someone comes along and buys the company." In essence, the conundrum is how to curb the excesses of the takeover game without eliminating legitimate and useful acquisitions.

While there is little likelihood of immediate congressional action to curtail destructive takeovers, other institutions are making some tentative moves. The N.Y.S.E. last July proposed a change in its 60-year-old "one share, one vote" rule prohibiting the trading of shares in companies that issue both voting and nonvoting common stock. Under the revised rule, corporate managers and other insiders could issue the voting stock to themselves and the nonvoting shares to other investors, thus retaining control of the company. Corporate Raider T. Boone Pickens has denounced the measure as the "ultimate in management entrenchment devices." So controversial is the Big Board's proposal that the SEC will hold public hearings on the topic starting in December.

Another limited takeover restraint has already been put in place by the Federal Reserve. In January the Fed board ruled that in some cases junk bonds could be used to provide no more than 50% of the financing for takeovers. The Fed ruling is a very narrow one and, so far, has not done a great deal to halt the junk-bond financing trend. But, having taken an initial step, the central bank may eventually decide on further action.

The broader issues of institutional behavior in the stock market and the volatility introduced by computer trading remain among the most contentious of all. Many stock-market experts dispute Drucker's thesis that the stock exchange has become more of a forum for speculation than for long-term productive investment. Says Steven Einhorn, a market strategist with Goldman, Sachs: "The market has not been taken over by people who have a 30-second time horizon. Young companies with good products are traded at high premiums because investors take a long-term view."

Indeed, a study by SEC staffers has shown that when publicly traded firms announce major investments in long-term research and development, their stock prices tend to rise. One example frequently cited by marketplace defenders to show that investors can still embrace long-range results: Genentech, the California-based biotechnology firm that went public in 1980 to a tumultuous market reception, even though it had not yet brought out its first products.

As for the ability of U.S. firms to compete internationally, some experts cite other factors besides stock-market pressure, like the cost of borrowing money, as reasons why American companies tend to focus on the short run. Says Frederic Scherer, an economist at Swarthmore College: "The cost of capital is higher for Americans, which means they have to show an earlier return on their investments. Cheap money allows the Japanese to take a longer view."

What seems abundantly clear, though, is that the quick-reacting computerized market is faster and more brutal in punishing corporate managers who make mistakes or whose company or industry is badly positioned. But some experts also feel that, over time, the volatility introduced by program trading will flatten out.

At the SEC's request, the Big Board has taken a small stab at curbing the ups and downs but with little success so far. On Sept. 19, the N.Y.S.E. experimented with a procedure of informing the trading floor half an hour before closing of the major holdings at that time in the stocks that compose the Dow. The aim was to allow counterpositions to be built up by competing traders, and thereby smooth some of the program-trading swings. The SEC hopes to repeat the experiment in December. The problem, though, is that the times when the market gyrations will take place are almost impossible to predict.

Whatever regulatory tinkering is tried, current stock-market trends cannot be entirely reversed. Some of the benefits that computerized trading confer on institutional investors vs. individual investors are permanent. One of those advantages is the ability to buy and sell entire portfolios of stock at once, rather than individual issues. Admits SEC Commissioner Joseph Grundfest: "One of the wonderful things about Wall Street has been that the small investor could lay the same bets as the big boys. Now you might need $9 million to play." He adds, "If you're not computer sophisticated, you're behind the eight ball. As a practical matter, small investors can't compete in program trading." Unless, of course, they become institutional investors themselves through mutual funds, which seem likely to continue to grow.

The market's advocates point out that computer-driven trading is at least as responsible for the stock market's spectacular heights as for its frightening lows. And from the very beginning of stock trading, the risks and rewards inherent in that ceaseless up and down motion have been exactly what brought investors to exchanges in the first place. Enthuses George Noble, manager of a $1.7 billion foreign stock fund for Boston-based Fidelity Investments, a mutual-fund group: "If you are insecure or you can't stand to lose, this is the wrong business to be in. It is a game in which you are pitted against thousands of other investors who are trying to outsmart you." The stock market may be faster, rougher and more complicated than ever before, but for all its painful perils and uncertainties, it is still the best game of its kind in town.