Business & Technology
Fasten your seat belts
Why financial markets are so much more volatile today

BY FRED VOGELSTEIN AND WILLIAM J. HOLSTEIN

John Hague glances at the bank of computer monitors before him and remembers with bemusement his first days as a Salomon Brothers bond salesman. It was only 13 years ago, but it might as well have been back in the Stone Age. He took customer orders on 8½-by-11-inch tickets and kept track of his daily transactions on a ledger, known as a blotter. He didn't sell anything more complicated than a Treasury note or a corporate bond.

Today, Hague, 40, a managing director for one of America's largest bond investors, Pacific Investment Management Co., never has to pick up a pen. Based in Newport Beach, Calif., he buys and sells hundreds of millions of dollars of bonds and derivatives by pushing buttons on his computer. With a few more keystrokes, he gets real-time information about markets from Tokyo to New York to London from Bloomberg and Reuters terminals. And when Chairman Alan Greenspan of the Federal Reserve Board speaks, Hague can watch it on CNBC and at the same time download Greenspan's remarks from the Fed's World Wide Web site. His phone has 64 lines, and the $250,000 worth of computer equipment on his desk has as much power as a roomful of mainframes in the old days. He wonders, however, whether all the technology is helping or hurting. "The degree of volatility is like nothing I've ever experienced," says Hague.

Up down, up down. He's not the only one. An outbreak of volatility is roiling nearly every market around the world, from foreign exchange and government bond markets to those for stocks and commodity futures. Last Thursday, for example, the Dow shot up like a bottle rocketËnearly 300 points, or 4 percent, in the space of 30 minutesËafter the Fed cut interest rates by a quarter of a percentage point.

Part of the explanation is that faster computers and faster transmission lines mean faster access to informationËand that translates into more transactions and lower costs. Equally important, more and more investor wealth is held in liquid form, not in tangible assets such as oil or grain or metals, and this "hot money" is ready to move in the blink of an eye. The proliferation of 24-hour business television channels, news agencies, and Internet services also has contributed to the sudden fluctuations. The "feedback loop" that shapes investor decisions is more immediateËand more easily swayed by expectations and rumors than hard facts.

All of these trends have been building for years, but they have reached the point that the very structure of today's markets seems to guarantee volatility, whether to the upside or the downside. "The speed of transactions is increasing geometrically as information and technology allow it," says Wall Street veteran Mike Holland, now chairman of Holland & Co., a private investment company. "That volatility is here to stay."

The violent ups and downs now last longer and appear to be more generalized than during single episodes of volatility like the Black Monday stock market crash of 1987, the bond market meltdown of 1994, and the Mexican peso crisis later that year. It's not fair to blame just hedge funds and other high-wire investors playing games with other people's money. Mainstream banks and investment firms on Wall Street take part in today's money games, as became evident following the implosion of giant hedge funds like Long-Term Capital Management. And millions of Americans are indirect participants through their mutual funds and pension funds, which together manage an estimated $12.3 trillion.

Motion sickness. The resulting volatility has been teeth-rattling, shaking some of the world's most important financial indicators. Since the stock market peaked on July 17, the Dow Jones index has witnessed 2 percent swings up or down on 14 occasions, or on about 23 percent of its trading days. In the entire post-World War II era up to mid-July, the Dow moved that sharply only on about 3 percent of the days it traded, according to Birinyi Associates, a market analysis firm. In the huge foreign-exchange market, where some $1.5 trillion routinely changes hands a day, the markets knocked 10 yen, or 7.5 percent, off the value of the U.S. dollar in a single day earlier this month, the biggest movement in two decades. Likewise, the yield of U.S. government 30-year Treasury bonds moved from 4.70 percent to 5.15 percent in just a day, nearly half a percentage point. "When I first got interested in financial markets, a quarter-percentage change was a huge change," marvels Allan Meltzer, a Carnegie Mellon University professor and chairman of the Shadow Open Market Committee, which monitors decision making by the Federal Reserve.

Continued investment in technology seems to guarantee that trading volumes will get even bigger. The 684 million shares traded on the New York Stock Exchange on Black Monday 11 years ago is now considered mild. There have been 11 days since mid-August when about 900 million or more shares changed hands, and Black Monday doesn't even rank among the top 10 busiest days on the Big Board. The record is now 1.2 billion shares, set on September 1. The Big Board's computers are so massive that the exchange now says it could handle more than 2 billion trades a day, and it's gearing up to handle 5 billion trades a day by the fall of 1999. Investment firms are engaged in a similar race. Merrill Lynch alone spends $1.5 billion a year on information technology; overall, Wall Street spends more than $10 billion annually on it.

Computers are directly related to the proliferation of derivatives, swaps, and other exotic instruments that financial rocket scientists concoct and then sell. An independent money manager equipped with a Sun Microsystems desktop workstation, for example, can take a pool of mortgage loans and "slice and dice" them, in the vernacular, to create new synthetic products. One collateralized mortgage obligation (CMO), for example, could offer investors a specific rate of return over a specific period of time, but another might offer different returns. Calculating the relationships among those instruments and setting prices is exacting work. "When I was working on the first CMO in 1983, it took me and another colleague 48 hours nonstop to do it," says Steven Guterman, executive vice president of American General Asset Management in New York. "Now computers can do that work in 30 seconds."

The machines are ubiquitous in another wayËin actually making the decisions about when to buy and sell. In computerized trading, the mathematical formulas that have been fed into machines are automatically buying and selling on a massive scale without any human telling them what to do.

Technology gets most of the blame for volatility, but markets couldn't generate big swings unless there were large pools of capital on tapËand increasingly, there are. One reason is that most American savings aren't parked in sleepy bank accounts or local S&Ls anymore. They've been pooled in superefficient ways in mutual funds and pension funds. That means a greater percentage of the nation's savings isn't being invested in local mom and pop businesses but instead is chasing fractional gains in global markets. "Years ago, if you wanted to make a stock purchase, you'd have to go to the bank, draw the money or get a bank check, then go and give it to your brokerage," says Jeremy Siegel, professor of finance at the Wharton School. "Now you just call up and say, 'Give me 1,000 shares of IBM.' " With the spread of automated voice-activated telephone systems, millions of Americans are doing just that, or else shifting funds in their 401(k)'s and IRAs.

Must-see TV. Shaping everyone's investment decisions are 24-hour nonstop information flows. Before many Wall Street money managers can get home in the evening, markets are opening in Asia and investors can hear or watch which way the Nikkei is moving. Then when they wake up, they hear about European trading, and about how S&P Index futures and Dow futures are faring. That drives the opening sentiment of U.S. markets.

The experts are divided about whether volatility is inherently benign or evil and what, if anything, should be done about it. Many Wall Streeters love volatility because they make money from it: Lots of buying and selling means lots of commissions. But aside from the profit motive, Carnegie Mellon's Meltzer says hair-trigger markets actually do a good job in absorbing negative news and constantly recalculating risks in a far more effective way than in the more heavily regulated economy of old. "Financial markets are buffering the real economy," says Meltzer. "They're changing the prices rapidly to reflect new conditions. That's a good thing."

But some experts like former Fed Chairman Paul Volcker are beginning to argue that restraints should be applied to unfettered, massive flows of short-term capital across national borders. Officials like Greenspan and Treasury Secretary Robert Rubin are trying to decide if they should control those flows in some way. They've seen how the sudden exodus of billions of dollars from Russia, South Korea, and Indonesia has brought those economies to their knees. What will happen, they ask, if such an exodus hits Brazil or MexicoËor worse, the United States itself?

Even Michael Bloomberg, who created the financial news service that bears his name, has some misgivings. "We've made the mistake of turning over judgment to computers," he told hedge-fund managers in Bermuda last week. But computer trading isn't about to disappear, and neither is volatility. So fasten your seat belts and try to enjoy the ride.