What's Going Down

By GEORGE J. CHURCH

Damn! The economy is strong. Production, sales, incomes are up. More people are finding jobs. Damn! Nobody on Wall Street would use those exact words; they sound too hardhearted. But the essential thought is voiced by many analysts trying to explain last week's sudden bust in the stock and bond markets (which is no easy job). In extenso, their reasoning goes like this: a strong economy threatens a revival of inflation, at least in the minds of the governors of the Federal Reserve Board. It also means higher interest rates: automatically, because of rising loan demand from business and consumers, but even more because the Federal Reserve is actively pushing up rates to ward off the not-yet-visible inflation. Rising interest rates by definition mean lower bond prices. And falling bond prices pull down stock prices too. "The economy is doing well, and the market is doing terribly," sums up Byron Wein, chief U.S. market strategist for the investment firm Morgan Stanley.

Even on Wall Street, that sounds like twisted logic to some. "The rational reasons for the sell-off ((inflation worries and interest rates)) in my mind just barely border on the rational," says Stephen Quickel, editor of U.S. Investment Report, a biweekly newsletter. Michael Metz, chief investment strategist for Oppenheimer & Co., concurs: "Financial markets have a world of their own and motivations of their own."

If such experts as these are puzzled, what are new investors to make of the tailspin? That question worries market professionals more than almost anything else. Since the 1987 crash gave way to a new boom, millions of investors have put a few thousand dollars each into the market, mostly by way of mutual funds. The great majority are getting their first bitter taste of a down market. If they panic and sell out, they could turn a downward spiral into a genuine crash.

So far, the so-called little guys have kept their cool. Rationally enough, most have stopped putting new money into stock or bond purchases, but few are rushing to sell. "I've done nothing," says Don Halbert, 41, a project leader and biologist with Abbott Labs in suburban Chicago. "I had a couple of stocks that were doing so well that at the beginning of last week I decided it was time to sell them. But then the market started to die, so I'm hanging on to everything," at least until prices recover a bit. After 2 1/2 years in the market, Aimee Swenby, 31, an executive assistant at a financial planning firm, and her husband John, 37, have sold, on the advice of a planner who told them to cash in some of their gains, 25% of the $20,000 worth of mutual-fund shares they had accumulated. They intend to hold the rest. Says Aimee: "I have & confidence the market will come back."

But can small investors stay calm if they have to endure more weeks as nerve-racking as the past two? In the five trading days between Thursday, March 24, and Wednesday, March 30, the Dow Jones industrial average fell almost 243 points, or more than 6%. Rallies interrupted the downfall only briefly; on some days prices dropped sickeningly in a matter of minutes, as computers at some big investment houses reacted to preprogrammed signals and sold huge masses of stocks. On Thursday, just before stock trading was suspended for Good Friday, the Dow average of 30 blue chips finally squeezed out a 9.21-point gain -- but that was misleading; in the broader market many more stocks fell than rose. Moreover, the roller-coaster ride -- up 20 points, down 72, then back up, then down -- was the wildest yet. On a normal day the Dow average may fluctuate 40 to 50 points; Thursday the swings added up to 380 points.

Can such dizzying gyrations be explained solely by worries about inflation and interest rates? No; analysts also emphasize two factors internal to the markets. To begin with, stock and bond prices by late January may well have been bid up higher than any financial logic would justify, largely by money seeking a higher return than was available on other investments. Thus prices were exceptionally vulnerable to even such a mild blow as the Federal Reserve administered on Feb. 4 when it raised a key short-term interest rate a quarter-point (the Fed added another quarter-point boost on March 22).

Once the slide began, it was aggravated by the operations of complex new investment vehicles called derivatives, a parallel world of side bets designed to hedge against the fluctuations in various markets. These derivatives can be enormously profitable, but they can also make trading even more volatile (see following story). Last week in the bond market, for instance, the managers of big hedge funds, which use derivatives to speculate, were caught in a vise. They had bought bonds heavily with borrowed money, betting that the prices would stay high. When prices dropped instead, reducing the collateral value of the bonds, the traders were forced to dump their holdings for whatever they could get to raise cash to pay off the loans. Their selling "just opened a black hole under the bond market," says Charles Clough, chief investment strategist for Merrill Lynch.

Whether analysts put more emphasis on inflation and interest rates or on internal market factors, however, they agree that the market crack does not point to any weakness in the "real," goods-and-services economy; it may even be a perverse sign of strength. That is also Bill Clinton's view. On Thursday, when the Dow average closed about 9% below its Jan. 31 peak of 3978, the President asserted that "the underlying American economy . . . is healthy and it is sound." The "skittishness" in the financial markets should not alarm anybody, he insisted: "Every single report I have ((points to)) very solid economic growth."

A President who takes that line always risks sounding like Herbert Hoover in 1929. But Clinton has the numbers on his side. In March more Americans found jobs than in any other month in more than six years. Nonfarm employment grew by 456,000, the biggest rise since October 1987. Though the unemployment rate paradoxically remained at 6.5%, some government analysts hailed the report as indicating that the era of what has been called "jobless recovery" is coming to an end.

Other indicators are also strong. Personal income rose 1.3% in February, its largest increase since April 1993. Consumer spending, which accounts for two- thirds of all U.S. economic activity, went up 1%; it has advanced 11 months in a row. There are a few negative signs as well: slight declines in factory orders and construction spending. And nobody expects output of goods and services to grow at anything like the gangbusters annual rate of 7% achieved at the end of 1993; that was just too fast to be sustained. But Laura D'Andrea Tyson, chairman of the Council of Economic Advisers, says the latest statistics "paint a picture of a moderate, sustainable recovery" -- one that is likely to lift production about 3% this year and create 2 million new jobs. Some other analysts think that pace will at last bring the unemployment rate below 6% by year's end.

Such predictions, however, are not at all what many Wall Street traders want to hear. The markets for some time have been treating every bit of good economic news like a tiding of disaster, because it seems to foretell more inflationary pressure and a further rise in interest rates. When the employment figures were announced last Friday, the bond market was open and gave the cheerful news dismal reception. Prices, which had begun to rally the day before, dropped sharply: 30-year Treasury bonds lost $19.38 for each $1,000 of face value, and the interest yield rose to 7.28%, the highest since January 1993. David Hale, chief economist for Kemper Financial Companies, had been expecting stock prices to begin rebounding this week but abruptly changed his mind after reading the employment figures.

There is no consensus on how much further the downturn may go. Instead, a lively debate is going on between those who think that the stock-market drop is a classic "correction" -- meaning stock prices go down around 10%, in which case the decline would now be almost over -- and others who believe Wall Street is in the first stages of a true bear market. In that case, the decline would not be even half finished; a bear market usually means stock prices plummet 20% or more.

There is no controversy, though, over what -- and who -- started the spin; it began as soon as Federal Reserve chairman Alan Greenspan began raising interest rates. A hot dispute still rages as to whether there is really enough of a threat of inflation to justify his course. The argument in favor is that the economy is fast approaching two guideposts. If U.S. factories operate at more than 85% of capacity, this theory holds, and the unemployment rate drops below 6.2%, shortages of goods and labor start to push up prices rapidly. The economy is not there yet -- but at an operating rate of 84% and an unemployment rate of 6.5%, it is no longer far away. The time of arrival is debatable, but David Wyss, economist at DRI/McGraw-Hill, a major economic forecasting firm, believes there is good reason to fear rising inflation "a year, year and a half away, and so now is the time when the Fed has to start tightening."

The opposite view is that the old rules of thumb are no longer valid. The U.S. is much more a part of the world economy now, and there is ample unused production capacity overseas. Any shortages can be filled not by pushing the operating rate of American factories to high-cost levels or bidding up the wages of scarce labor but simply by buying from abroad. At home labor costs per unit of output are going down, a consequence of rising productivity, and falling oil prices are putting another damper on inflation. In fact, consumer prices in the past three months have risen at the extremely low annual rate of 1.9%. No one thinks that can last. But one Clinton economic adviser sees excellent chances for a year of "double threes" -- production and prices both rising a comfortable 3% this year.

In any case, rightly or wrongly, the Fed did start raising interest rates -- and what Greenspan may have intended to be a warning shot across the bow of speculators, as one analyst puts it, sounded to many investors and traders like the crack of doom. Metz of Oppenheimer explains some reasons: the Fed had previously been driving interest rates so far down that savers were getting as little as 3% on CDs -- effectively zero, when matched against the rate of inflation. To get even a chance for a real return, "they were forced into the stock and bond markets." Not just little investors, either: banks and hedge funds became "enormous buyers of bonds" because they could borrow at 3% and buy bonds yielding 6%, making a big profit immediately and expecting it to become even bigger as prices rose also. The Fed's move reversed all the calculations: stock and bond prices that looked reasonable, if high, at January's level of interest rates seemed way out of line at whatever one guessed might be the new level the Fed was aiming for.

As always in the financial markets, however, rational calculation was only part of the story. A cascade effect quickly began. Some Japanese investors are said to have dumped U.S. Treasury bonds they were holding when interest rates began going up, accelerating the price decline. That aggravated the squeeze on hedge funds, which dumped heavily. And some money managers seem to have panicked, fearing that the Fed's move must mean the threat of inflation was far greater and more imminent than they had realized -- so better sell, sell, sell.

What happens next depends partly on what small investors do, how many speculative bond and stock holdings financed by borrowed money still have to be unwound -- and also, of course, on what the Fed does. One guess is that Greenspan may push rates up another half to three-quarters of a point but let it go at that. If so, the economy may slow somewhat, particularly as higher interest rates translate into more expensive mortgage, car-purchase and credit-card loans. Tyson, however, thinks any such effect would only balance forces that may be working for a faster expansion, keeping growth at the overall desired, moderate, low-inflationary 3% -- at least for the rest of the year. That of course is the optimistic scenario. The pessimistic one? Well, there is an old joke about the store owner who was miffed that no one would ask him, "How's business?" -- but when he finally did prompt someone to raise that question, clapped his hand to his head and moaned, "Don't ask."

CHART: NOT AVAILABLE

CREDIT: [TMFONT 1 d #666666 d {Sources: Datastream, the Conference board, Blue Chip Economic Indicators}]CAPTION: Dow Jones industrials weekly closings

With reporting by John F. Dickerson and Jane Van Tassel/New York, Suneel Ratan/Washington and Leslie Whittaker/Chicago