So computerized program trading has now brought the stock market to the point where it fluctuates more in one hour than it once did over weeks, or even years. The reference, of course, is to the 116-point fall in the Dow Jones industrial average on Friday. Trading in stock index futures was involved in that fall, as it was last September, when the Dow average fell 120 points in two days.
In fact, the techniques of trading common stocks the way grain and livestock markets trade wheat, cattle and hogs is getting a reputation for causing increased volatility in the stock markets--a pattern of faster and wilder price changes that some people regard as excessive and unstable. Over the weekend, Treasury Secretary James A. Baker III and Chairman John S. R. Shad of the Securities and Exchange Commission both expressed concern over the market's fluctuations and pledged to "take a look" at program trading.
Will something now be done to slow the action? Almost definitely not. Baker and Shad made political statements in the nervous aftermath of Friday's market. But both men know that it would not be easy to dismantle the business that has grown up around trading in stock market futures contracts. The futures essentially are bets on whether the market will go up or down, and professional investors use them to hedge against the risk of loss in their stock portfolios or to make a quick buck on temporary discrepancies between the futures prices and those of the underlying stocks.
Furthermore, both Shad and Baker know that the use of futures contracts is even now spreading to mutual funds, the institutional investors for the general public, and that the new tax reform law is encouraging that development--allowing the funds to get into futures and other trading methods. Dreyfus Corp. has two new funds that will use such techniques, and Oppenheimer & Co. will shortly bring out a fund that will use futures trading to hedge the risks. Individual investors are precluded from such hedge trading, since it takes $10 million minimum to set up a program trading operation. Hence, a new opening for the mutual funds.
What's really going on? The spread of investing and trading techniques from the century-old Chicago grain markets to the present-day management of pension and mutual funds. Just as farmers didn't want to risk losses on their corn crops, so money managers dare not risk loss of principal in their portfolios.
Narrowing the Odds
Historically, the farmer, the grain miller and numerous middlemen and speculators have transferred the risk of fluctuating prices for corn by exchanging contracts for future delivery at specified prices. So today, the pension fund manager with investments in the stocks of major U.S. companies might hedge those investments by selling a futures contract on the Standard & Poor's 500-stock index. If the stock market then fell, and with it the value of the investment portfolio, the manager would still be able to collect the old higher price for the futures contract, offsetting part or all of the loss on the actual stocks.
How can an activity that sounds so prudent seem so disturbing? Because futures markets involve a lot of speculators, who add to the volume of trades and narrow the price spreads in much the same way that numerous bettors at a race track narrow the odds. Futures markets encourage such participants by allowing them to make their bets with only a little cash outlay. For example, the value of the S&P 500-stock index future currently is $136,000. But a professional investor has to put up only $3,000 or so in cash to buy that futures contract--a margin of 2.5% when the same investor has to put up 50% in cash to buy the actual stocks on margin.
Thus, last Friday when many people thought the stock market had gotten too high, the cheap way to bet on stocks going down was to sell futures contracts "short." That means such bettors would sell borrowed contracts in hopes that prices would fall, allowing them to buy and return contracts at a lower price. A lot of people had the same idea on Friday and futures prices plummeted. But that in turn triggered other portfolio programs into selling the actual stocks, and for a brief period the markets became disorderly as buyers disappeared. The market turned back up, in fact, when speculators bought futures contracts at prices far below those of the underlying stocks.
Did the futures contracts cause the stock market to fall? No, investor sentiment that the market had gotten too high caused prices to turn. Did the futures selling cause prices to fluctuate more than they would have in days before program trading? Measured on a one-day basis, of course they did. Measured on a long-term basis, the jury is still out.
That may be a question for the government to look at, but it is unlikely at this point to curb computerized trading. Unnerving as it may be, investing professionals think we're safer with it than without. And, if the market doesn't collapse under the weight of all that hedging, bewildered average investors will get a chance to judge for themselves through the mutual funds.