Sometimes markets go a little crazy

This week's upheaval can be traced partly to investor uncertainty

March 02, 2007|By JOHN HANCOCK

Whack! Just when you thought stock-market gyrations had gone the way of Enron, the Dow Jones industrial average plunged 416 points Tuesday, rose 52 on Wednesday and then fell 200 early yesterday only to ascend almost as much by lunchtime.

The era of steadily rising 401(k) plans and no-sweat investments in international mutual funds is over, at least temporarily. Last week The Wall Street Journal reported that the Dow hadn't fallen by more than 2 percent since July - the longest such period since 1954. On Tuesday the streak ended, and a new one might not start anytime soon. I consulted experts on why markets go crazy - become volatile, both up and down. Part of the answer is as old as stock exchanges: Investors panic sometimes. And part is new, having to do with lightly regulated investments called hedge funds.

Over long periods, U.S. stock prices tend to grow with the economy. So why do stocks sometimes check into the elevator shaft?

One reason is uncertainty. Stocks are pieces of companies. Unlike payments from a bond or a bank deposit, corporate profits hinge on numerous factors that are hard to predict. When assumptions about profits change rapidly, so can the stock market.

"Ultimately, when we look at volatility, we're looking at information that people have a hard time digesting," says Robert F. Engle, a New York University professor who won the 2003 Nobel Prize in Economics for improving volatility analysis. "It's fundamental uncertainty about what the outlook is."

But the Dow dropped 3.3 percent between Tuesday morning and Tuesday evening. Did the world change so much in eight hours?

No. But perceptions of the world did. More importantly, so did investors' perceptions of other investors.

As the economist John Maynard Keynes noted in 1936, the way to bet on a beauty contest is not to pick the prettiest contestant; it's to pick whom you think the judges will deem the prettiest. (I'm simplifying to make the point.) This week investors became less confident that the world's financial judges - other investors - will find stocks attractive.

The Dow hadn't had such a bad day in years. Why were markets so calm for so long?

The popping dot-com bubble in 2000 and the terrorist attacks of 2001 prompted monetary authorities to inject huge amounts of money into the economy.

The dollars buoyed all investments - from houses to stock markets. And they prompted people to plow money into traditionally risky vehicles - not just U.S. stocks but also emerging markets, junk bonds and low-quality mortgages - without thinking too much about whether prospective returns would justify the risk.

But that set the stage for today's volatility.

"The general investing public has been taken by a Panglossian view of the world," says Steve H. Hanke, professor of applied economics at the Johns Hopkins University. "Risk is so incredibly underpriced, you're getting paid very little to take risk of any kind."

For example, Hanke said, some high-risk, emerging-market bonds have been paying annual interest of only 1.5 percentage points more than rock-solid Treasury bonds - a teeny difference by historical standards.

Now that market disruptions have called the safety of such investments into question, they're being sold, too - adding to the volatility.

"There was a tendency for people to get caught up in a `new regime,' `new paradigm' story and think we're in a low-volatility world for the indefinite future," says William Cheney, chief economist at John Hancock Financial Services. "And we're not."

You're saying that volatility causes more volatility?

Absolutely. Very often a choppy market "begets a period of volatility," says Barry Ritholtz, chief market strategist for Ritholtz Research in New York. "There's not enough data to say it's conclusive, but you can see that once you get a major day and there's an ugly selloff, you wind up with a lot of swings in the market."

Everything is connected in the global economy, which is why big swings in Shanghai cause trauma in New York. One result of the huge growth in credit and the money supply in the past few years is that hedge funds - essentially unregulated mutual funds - have borrowed billions to make risky market bets.

Hedge funds almost certainly contributed to this week's rocky ride. And the financial world is holding its breath to see if it will cause some hedge fund to run into trouble and threaten further damage, as Long Term Capital Management did in 1998 or Amaranth Advisors did last year.

Says Nariman Behravesh, chief economist for Global Insight in New York: "I'm guessing this volatility will be with us for a while - maybe three months or six months."

Can volatility be measured?

Yes. The Chicago Board of Exchange trades a volatility index tied to options on the S&P 500 stock index. Pros call it the "Fear Index" because it gauges predicted volatility - up or down - over the next 30 days. On Tuesday the index jumped 80 percent, although it's still below where it often was in the 1990s - a period of generally rising stock prices.

jay.hancock@baltsun.com

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