Wall Street Volatility in wall street
ulhasj at bom4.vsnl.net.in
Tue Nov 16 17:28:23 PST 1999
14 November 1999
Volatility in wall street
The U.S. economy, with its miraculous growth, has continued to surprise the
world. In spite of many pessimists warning about its impending collapse, it
has gone on from strength to strength. The continuing boom in the U.S. stock
markets has itself powered growth. One feeds on the other -- the economy
invigorated by the stock prices and the latter encouraged by the growth of
In December 1996, Mr Alan Greenspan, the chairman of U.S. Federal Reserve,
had raised serious doubts about the sustainability of a continuing rise in
the stock prices. He asked pointedly, ``How do we know when irrational
exuberance has unduly escalated asset values, which then become subject to
unexpected and prolonged corrections?'' The Dow, which was at 6,500, stands
today at nearly 10,500. The markets heard but did not heed Mr Greenspan. The
high stock prices in the U.S. stock markets have led to a feverish rush of
investors into the stock markets.
The central banker's concern about high stock prices is based on two
important considerations. One is that the stock market in the U.S. displays
a rather irrational attitude to price earnings ratios, especially in respect
of technological stocks. Internet stocks, in particular, have valuations far
out of proportion to their earnings. Indeed, there are companies, like
Amazon.com, whose profits are negative, but whose stock price booms. The
investor is fed on hope. Any adverse news leads to a sharp fall.
The second disturbing feature is that the U.S. banks are involved, albeit
indirectly, in financing those, who hold stocks. The U.S. credit system
allows loans against share, with a margin of 50 per cent. In addition, the
hedge funds leverage their holdings many times over. Any rise in stock
prices gives the U.S. stockholder a sense of improved wealth. Nearly one
half the American households are holders of stock. As the investor feels his
wealth increasing with rise in the market, he can draw more credit. The
consumption boom in the U.S. is thus increasingly the result not of
increased savings but of credit based on higher valuation of equity.
Any disruption of the upward climb of the Dow can be disastrous to the
extent margin calls will mean the consumer will have less to spend. A fall
in the Dow -- if it is sharp -- can create a devastation in the American
engine of growth of global economy.
There are differing views on the possibility of such a crisis. The coming
burst of the U.S. bubble is a favourite theme of certain economists,
particularly in the U.K. and Europe, who see an increasing similarity
between the rise and rise of the Nikkei in Japan in the late '80s, followed
by a disastrous burst. Japan has not recovered fully since.
There are also prophets of doom, who see a close resemblance to the position
that obtained before the great crash of 1929. Even in the U.S., there are
economists and observers, who feel that in spite of increased productivity
of the U.S. economy, there is a substantial potential for a fall in the
Over the last six months, if we take away the technology shares, the rest of
the U.S. market has been languishing. The moving average of falling U.S.
stocks has been higher than that of those rising. In fact, 60 per cent of
the U.S. stocks were down during the year gone by.
What is holding up the Dow is the increasing presence of technology
stocks -- a factor which has become even more important with the latest
addition of Microsoft and Intel to the 103-year-old Dow index. The irony of
it was that just when the Dow was so strengthened, came the adverse decision
on the Microsoft case in the U.S. came. The Dow got hit.
The volatility of the stock markets is a given, any where. But in the U.S.
stock markets the boom is sustained in part by the flow of funds from
abroad. The U.S. deficit on current account runs at around $ 220 to 250
billion, met mainly from foreign private inflows and official forex reserves
of other countries. How long will this capital inflow last? If the
confidence in the U.S. market declines, because of a sharp fall in the
index, the supporting capital flows may not be sustained and the U.S. dollar
may fall, leading to further distress.
Mr Greenspan has recently revisited to the issue of volatile stock market
prices. He has referred to recent controversies about equity prices. Some
economists had even said that, thanks to the changing productivity of the
U.S. economy, the``equity premium'' -- the higher price investors are
willing to pay for equity over borrowings -- is itself rising. They argue
that, as a result, the Dow may actually go up to 36,000 in the next decade.
Chairman Greenspan does not obviously agree with such rosy forecasts. He has
cautioned banks and the markets against assuming that such a rise is
inevitable and taking too many risks.
Half in sadness and half in joke, Mr Greenspan said recently, ``The
sophisticated risk models used by bankers have not made people with grey
hair or none wholly obsolete.'' While Mr Greenspan is surely not obsolete --
however grey-haired -- hubris goes on. Bankers and investors continue to
play the markets. They tend to prefer not to hear Greenspan's cautionary
What does all this mean for India? First and foremost, we also should take
care, lest our investors also are carried away by an irrational exuberance
of the market. Especially I fear this, because the structure of our
corporate disclosure laws and insider trading restrictions is still weak --
in spite of the reform process -- compared to developed economies.
Manipulative operations are still reportedly going on, although on a much
With increasing dematerialisation of shares, banks have been emboldened to
lend against equity, even if it be on a limited scale. Hopefully
manipulative operations of the kind that had led to the transient, but
disastrous boom of 1991-92 do not continue today. But the central bankers
and Sebi can never be too careful.
We are in an integrated global economy. If there is a fall in the Wall
Street, it can have serious repercussions around the world. We should have
ready contingency plans to react, to safeguard our financial sector if the
American bubble bursts.
We can of course live in hope that the American miracle will continue
forever. But the path of wisdom lies in preparing ourselves for the prospect
of a shakedown, however unlikely it may look now.
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