Another form of program trading is called “stock-index arbitrage.” A position in a portfolio stocks is combined with an index futures contract with the objective of producing a perfectly hedged position and an abnormally large risk-free return. Arbitrage opportunities arise whenever the value of an index future and the value of the underlying security diverge.
The benefits of index arbitrage are twofold. First, by increasing trading in both underlying stocks and derivative products, liquidity in both markets is enhanced. Second, arbitrage trades link markets together and ensure that both the underlying securities and the derivative instruments are appropriately priced.
But have program trading and the use of derivative products increased volatility in the stock market? In part, the apparent increase in volatility is the result of a scale effect. A daily move of 50 points with the Dow Jones average near 2,500 is no greater than a 16-point move during the early 1980s with the Dow at 800. Through the end of the 1980s, all the worst point declines in the Dow Jones Industrial Average occurred during the 1986-89 time period. When the price changes are recast in terms of percentage changes, however, most of the worst days in the market all occurred over fifty years ago.
To be sure, October 19, 1987, holds the record in terms of single-day loss, measured either in points or as a percent. Friday, the 13th, October 1989, was also an unusually volatile day. And stock market volatility during the 1970s and 1980s was higher than during the 1950s and 1960s. But there are, I believe, good economic reasons for this increase in volatility. During the 1950s and 1960s, inflation remained very low and stable. Interest rates and bond prices moved very little. We had fixed and relatively stable exchange rates with our major trading partners. Economic activity was also near full employment.
The basic economic environment became far less stable by the 1970s and 1980s. Inflation accelerated and bond prices became more volatile, especially after the Federal Reserve abandoned its policy of iterest-rate smoothing. Moreover,exchange rates also became highly volatile as world capital markets became closely integrated so that it was possible to move billions of dollars among currencies almost instantaneously. Unemployment rates in the 1980s became more volatile too, reaching levels not experienced since the 1930s. Thus, basic economic uncertainty increased dramatically, affecting all markets. Finally, trading has become far more concentrated – being dominated by large institutional investors.
I am convinced that the general increase in volatility of financial markets compared with the 1950s and 1960s reflects this increase in basic economic uncertainty and the growing institutionalization of our markets. Products such as futures and options arise to cope with this increased uncertainty. They are used by professional investors to shift and control risk and to respond to market movements. This means that the growth of derivative products results from an attempt to cope with increased underlying volatility. Blaming derivative products and related program trading for the volatility in the stock market is as illogical as blaming the thermometer for measuring uncomfortable temperatures. And even if they do make the market more quickly responsive to changes in underlying conditions or the sentiment of large institutions, this is a sign of a well-functioning stock market, not an inefficient one. Eliminating new instruments and trading techniques would make our markets less efficient and risk seeing institutions develop to facilitate such trading abroad.
After the crash of 1929, legislation was introduced to prohibit the use of telephones to transmit margin orders. At the start of the 1990s, program trading was the target. But technology does not move markets, it merely facilitates the flow or orders. Program trading is not the mindless computer-driven technique that keeps the market from reflecting fundamental values. It reflects human decisions about the value of stocks, made easier to execute because of computers. If institutions decide to sell, they will do so whether by computers, telephones, or even hand signals from open window to brokers outside as was the case in earlier times.
Obviously daily movements in the popular stock market indices that are large enough to catch newspaper headlines are upsetting, especially to the individual investor, who feels at the mercy of the large institutional traders. But should the wise investor then leave the stock market entirely, as some individuals have apparently decided? Absolutely not! To paraphrase a common expression, “if you can keep your head when those around you are losing theirs, you do understand the problem and know the best way to cope with it.” The long-term investor can and should ignore short-term market volatility. The losers from stock market volatility will be the institutions that trade frequently in a futile attempt to time the market, not steady individual investors who buy and hold for the long term.
I have emphasized that market valuations rest on both logical and psychological factors. The theory of valuation depends on the projection of a long-term stream of dividends whose growth rate is extraordinary difficult to estimate. Moreover, the appropriate risk premiums for common equities are changeable and far from obvious either to investors or to economists. Thus, there is room for the hopes, fears, and favorite fashions of market participants to play a role in the valuation process. Indeed, I emphasized how history provides extraordinary examples of markets in which psychology seemed to dominate the pricing process, as in the tulip-bulb mania in seventeenth-century Holland and the biotechnology boom in the late 1980s. Thus I harbor some doubts that we should consider that the current array of market prices always represents the best estimates available of appropriate discounted value.
Nevertheless, one has to be impressed with the substantial volume of evidence suggesting that stock prices display a remarkable degree of efficiency. Information contained in past prices or any publicly available fundamental information is rapidly assimilated into market prices. Prices adjust so well to reflect all important information that a randomly selected and passively managed portfolio of stocks performs as well as or better than the portfolios selected by the experts. If some degree of mispricing exists, it does not persist for long. “True value will always out” in the stock market. Moreover, whatever mispricing there is usually is only reconizable after the fact, just as we always know Monday morning the correct play the quarterback should have called.
Pricing irregularities may well exist and even persist for periods of time and markets can be influenced by fads and fashions. Eventually, however, any excesses in market valuations will be corrected. Undoubtedly, with the passage of time and with the increasing sophistication of our data bases and empirical techniques, we will document further departures from efficiency and be able to understand their causes more fully. But I suspect that the end result will not be an abandonment of the belief of many in the profession that the stock market is remarkably efficient in its utilization of information.
Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.