Whipsawed by Wall Street

Volatility is back big time--and Iraq isn't the only reason. Here's how the market is changing

Marsha Wineburgh's investment club has lost its zest for the stock market. The only stock the New York club bought over the past year was Procter & Gamble Co. (PG )--because Value Line Inc. rated it one of the least risky. Now the 11-member, all-women's Thursday Investment Team, which started as an investment discussion group in 1991, has decided to call it quits. They're turning themselves into something they can stomach--a dining club. Says Wineburgh: "We don't trust the market. We don't trust research. Bottom line: Stocks have just gotten too crazy."

Crazy, indeed. As we enter the fourth year of a ghastly bear market, investors are getting whipsawed by Wall Street. Stocks are swinging up and down more often and more violently than at any time since the Great Depression. As recently as 1995, the Standard & Poor's 500-stock index traded all year without once changing 2% in a day. But in 2002, it gyrated that much or more on 52 days--once in every five trading sessions--the most since 1938. The tech-laden NASDAQ now swings by at least 2% on two days out of five, vs. just once every 10 days nearly 30 years ago.

Market swings tend to be greatest during bear markets when risk is high and fear endemic. Clearly, a looming war with Iraq, worries about North Korea's nuclear weapons buildup, and the dark threat of terrorism on American soil all make for exceptionally nervous markets. "Now we have to worry about retaliation from terrorists," says Robert J. Shiller, Yale University finance professor and the author of Irrational Exuberance. Moreover, an invasion of Iraq could heighten tensions between the U.S. and other countries. If the friction persists, says Edward Kerschner, global strategist at UBS Warburg, it could reduce the global popularity of major U.S. brands, contribute to a weaker dollar, and keep stock prices down.

But market volatility may not retreat once the bear goes back into hibernation and the world has returned to relative peace. That's because fundamental changes are taking place that will likely alter investing and the very structure of the market for years to come. Millions of ordinary buy-and-hold investors, who have been a major stabilizing force in the stock market, are bailing out. If history is any guide, those investors won't jump back in quickly even when the market starts rising again. The last time they deserted in droves--after the bear market of 1973-74--they stayed away for the best part of a generation. "This is a new, rapid-fire trading kind of environment that just stymies average investors," says James W. Paulsen, chief investment officer at Wells Capital Management. "Old dogmas like `buy and hold' just don't work."

Long-term investing is taking a backseat to no-holds-barred trading by market professionals who jump in and out of stocks at dizzying speed. Today's Wall Street has all the characteristics of a traders' market--one in which the winners are those who can get in and out quickly while making small, yet frequent, profits. Hedge funds and other hyperactive pros charge through the market, firing off split-second trades and using elaborate strategies to wrench out profits. Program trading, in which professionals use computers to pump through buy and sell orders for million-dollar baskets of stock, is at an all-time high, making up nearly one-third of the New York Stock Exchange's daily trading volume. That's more than triple 1989 levels. And the short sellers--who borrow shares and sell them, hoping to buy them back at a lower price--are out in full force. Short sales are at near-record levels.

The stock market hardly pauses for breath these days. The spread of after-hours and global stock trading has eliminated natural circuit breakers that used to give wild markets a few hours' respite. Even bond market volatility has increased as interest rates have plunged and fueled mortgage debt prepayments. "All of these things have really changed the whole nature of the stock market," says Laszlo Birinyi, head of investment and research firm Birinyi Associates.

What's more, financial innovation will likely mean a changing market for quite a while. Pros now play with a dizzying array of complex products, from options on indexes to single-stock futures, that generate newer and ever more frenetic trading strategies. "This is a different market these days," says Tobias M. Levkovich, U.S. equity strategist at Salomon Smith Barney. "It's not true that history always repeats itself."

That's certainly the case with corporate earnings. As regulators crack down on accounting tricks, companies will no longer find it so easy to enhance profits or smooth them out through good times and bad. So earnings--and the price of stocks--will bounce around much more than before. In the past, says James F. Harrington, leader of national accounting technical services for PricewaterhouseCoopers, "Wall Street demanded consistency." Now analysts are suspicious of it, because it smacks of manipulation.

For most ordinary investors, this is the most frustrating time in memory. In fact, their entire investing approach may need to be turned on its head. To minimize the potential damage that market gyrations can inflict on their portfolios, they need to use techniques such as diversification and asset allocation assiduously. As ever, investments in cash, bonds, and a wide spread of equities, including value and growth stocks and small to large caps, remain the foundation. But investors may need to consider alternative investments such as gold, real estate, and commodities, as well as hedge funds and mutual funds that act like hedge funds. Why? Because such investments either don't move in lockstep with the stock market or aim to make money in both up and down markets. This is hardly a radical new approach. But, says Paulsen, "investors got so far from these practices, especially during the final phase of the bull market, that this age-old wisdom suddenly seems new."

Some investing gurus say worries about market volatility are overblown. Jeremy J. Siegel, Wharton School professor, high priest of buy-and-hold investing, and author of Stocks for the Long Run, argues that today's excess volatility is an aberration and "will be self-correcting." Stocks swung wildly in earlier bear markets and then settled down. Indeed, he expects that many of the new hedge funds now stirring up the market will burn through their capital and fold.

Many Wall Street strategists argue that the worst is over for stocks. Once the war with Iraq is finished, the bull market will resume, they say. They believe that stocks are again reasonably cheap and that distressing news headlines are about the only thing still holding them in check. For instance, Goldman Sachs & Co.'s (GS ) Abby Joseph Cohen said in a recent report that "ugly scenarios are already priced into financial markets, creating notable undervaluation."

But the hard truth is that the era of seemingly easy profits from stocks during the 18-year bull market that preceded the bust is over. Instead, investors may face years of below-par returns. "The 20th century was probably a lucky century, with the market averaging high annual returns," says Yale's Shiller. "There's no proof the market will do nearly as well in the 21st century." Even after the market settles down and starts to head up, many strategists say it may not produce much more than 7% to 8% yearly gains before inflation. At those rates, the S&P 500 would take a decade to return to its all-time high of March, 2000.

Why do the prospects look so bleak? For starters, the 27% average annual gains stocks made in the three years ended in 1999 were unsustainably high--more than double the 11% compound annual growth rate since 1925. Moreover, investors are waking up to the reality that Corporate America's earnings are becoming a lot harder to predict. Post-Enron, companies are putting forth more conservative business plans, investor confidence isn't likely to rebound so fast, and there's a lack of pricing power across the board.

In fact, says Richard Bernstein, chief U.S. equity strategist at Merrill Lynch & Co. (MER ), a big reason for the recent market volatility and falling stock prices is that investors are just beginning to see how vulnerable stocks are to unpredictable corporate earnings. "Investors have been underanticipating risk," he says. Sooner or later, they'll become less willing to pay up for stocks with more volatile earnings and wild price swings. And they'll demand lower share prices as compensation for the extra risk they're taking. "Even if a cyclical bull market reappears, it's likely to be modest," says Charles Pradilla, chief strategist at SG Cowen Securities Corp.

Already, the bitter cocktail of volatility and investment losses is driving ordinary investors away. In 2002, they yanked $27 billion from domestic equity funds and poured $124 billion into taxable bond funds--the biggest stock sale and the biggest bond buy in the 18 years tracked by the Investment Company Institute, the mutual-fund trade group. And this January, when heavy inflows normally supercharge stock funds held in individual retirement accounts, pensions, and 401(k)s, there were net redemptions (totaling $1 billion), for the first time since 1990, according to fund research company Lipper Inc.

Traders and hedge funds now dominate the market, thriving on the turmoil, often at the expense of ordinary investors. They're usually the first to trade on news or even rumor. And they often hunt in packs. For example, in early January, after Greenwich (Conn.) hedge-fund manager Edward Lampert was the victim of a bizarre kidnapping, many hedge funds started to short stocks such as AutoZone Inc. (AZO ), an auto-parts retailer that was one of Lampert's biggest holdings. Although Lampert was released unharmed the next day, hedge funds were betting the kidnapping would scare him into selling, says one source. It didn't, but AutoZone still lost some 15% in the two weeks after the abduction.

Pros trade index futures and baskets of stocks called exchange-traded funds (ETFs) faster than a 10-year-old playing Red Alert 2 on a laptop. Developed in the 1990s, ETFs with weird monickers like Spiders, Cubes, and Diamonds--respectively, baskets of the S&P 500, NASDAQ 100, and Dow Jones industrial average stocks--allow traders to buy and sell the whole market all day long. Daily ETF trading is worth more than 11% of the value of trading in NYSE and NASDAQ, vs. just 0.7% in 1997. Traders can short ETFs immediately after a previous trade in which their prices fell--something they haven't been allowed to do with regular stocks since the 1930s because it's akin to pouring gasoline on a fire. So selling pressure can build inexorably in ETFs in an already falling market.

The days when investors could expect blue-chip stocks to be worth about as much at the market close as they were in the morning newspaper are long gone. Consider General Electric Co. (GE ) Last year, its stock moved 2% or more a day 108 times, or two of every five days the market was open. Back in 1981, GE stock saw that much volatility only 10% of the time. Even during the craziness of 1987, the stock had only one hairy day in four. After it reported earnings below expectations on Jan. 8, Alcoa Inc. (AA ), the biggest aluminum producer in the world, plunged 10.4%, its biggest one-day drop since the October, 1987, crash. Such big moves used to be confined to tech stocks or risky small growth companies. But Alcoa shares have swung by 7% or more in a day 21 times in the past four years, vs. just 14 times during the previous 18 years.

Earnings surprises--and consequent lurches in stocks--are likely to become much more common as U.S. and international regulators change accounting rules in an effort to discourage corporate hocus-pocus. In January, the Financial Accounting Standards Board placed stricter limits on the special-purpose entities that some companies, including Enron Corp., used to manage earnings and keep debt off their balance sheet. Last year, FASB put the lid on corporate cookie jars by limiting the ways companies can set up special reserves, such as those for restructuring, and use them to pump up earnings in quarters when they droop. "Smoothing hides what has really been going on," says FASB Chairman Robert H. Herz.

More changes to accounting rules that could further depress reported corporate profits are in the wind. A big debate is raging about whether to force companies to expense the stock options they hand out to executives, a move that would cut earnings. And over the next two years, the accounting cops want both to stomp out the misuse of corporate pension funds to gussy up results and to limit the 100 or more ways that companies can boost their apparent sales with various tricks.

The corporate crackdown is having some unintended consequences that increase the likelihood of earnings surprises. For one, companies and Wall Street analysts are turning timid about predicting results. A few companies, including Coca-Cola (KO ), Pepsi (PEP ), AT&T (T ), and McDonald's (MCD ), have said recently that they will stop projecting quarterly earnings per share. And analysts, wary of scrutiny after the recent scandals about their conflicted research, hesitate to make bold calls warning the market that a stock is seriously out of kilter. "People stick their necks out less," says one analyst. "If you are right and perceptive, you're going to be investigated to see if you had inside information. And if you're wrong, you're not going to have a job."

On top of all that, the markets have to deal with heightened geopolitical risk. For instance, the Dow plunged 2.8% on Jan. 24 in advance of a report by chief U.N. weapons inspector Hans Blix. When Blix spoke critically of Iraq on the next trading day, the selling continued, taking the Dow to 7,990, nearly 10% lower than it had been two weeks before and more than erasing the New Year's rally. Then, on Feb. 24, the Dow plunged 160 points on war fears after surging 103 points the prior trading day. In fact, in the past eight months the market has oscillated from a 21% rally to a 19% decline to another 21% rally and a 13% decline.

We aren't necessarily condemned to a multiyear bear market. But perhaps investors should be prepared for several "mini-bear" and "mini-bull" swings of at least 20%, which occurred in the five years preceding the 1973-74 bear market and in the eight subsequent years. That's when swashbuckling traders such as Martin Zweig and George Soros cut their teeth. There are, of course, big differences today: Inflation is nowhere near the heights it reached then, interest rates are low, and the Federal Reserve has been proactive.

In any case, many average investors are again paralyzed by market uncertainty. Hiding behind decimated portfolios--or cash, if they're lucky--they're afraid to jump back into the fray. And they may be wary for some time to come. Investment clubs similar to Marsha Wineburgh's closed en masse after the 1960s bull market ended. Indeed, 25 years passed before investors were again meeting in as many clubs as in 1970. Let's hope we don't have to wait another generation before ordinary investors, and their steadying influence, return to the market.

By David Henry and Marcia Vickers in New York

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