|United States Economy
Capital markets in the United States provide the lifeblood of
capitalism. Companies turn to them to raise funds needed to finance the
building of factories, office buildings, airplanes, trains, ships,
telephone lines, and other assets; to conduct research and development;
and to support a host of other essential corporate activities. Much of
the money comes from such major institutions as pension funds, insurance
companies, banks, foundations, and colleges and universities.
Increasingly, it comes from individuals as well. As noted in chapter 3,
more than 40 percent of U.S. families owned common stock in the
Very few investors would be willing to buy
shares in a company unless they knew they could sell them later if they
needed the funds for some other purpose. The stock market and other
capital markets allow investors to buy and sell stocks continuously.
The markets play several other roles in
the American economy as well. They are a source of income for investors.
When stocks or other financial assets rise in value, investors become
wealthier; often they spend some of this additional wealth, bolstering
sales and promoting economic growth. Moreover, because investors buy and
sell shares daily on the basis of their expectations for how profitable
companies will be in the future, stock prices provide instant feedback
to corporate executives about how investors judge their performance.
Stock values reflect investor reactions to
government policy as well. If the government adopts policies that
investors believe will hurt the economy and company profits, the market
declines; if investors believe policies will help the economy, the
market rises. Critics have sometimes suggested that American investors
focus too much on short-term profits; often, these analysts say,
companies or policy-makers are discouraged from taking steps that will
prove beneficial in the long run because they may require short-term
adjustments that will depress stock prices. Because the market reflects
the sum of millions of decisions by millions of investors, there is no
good way to test this theory.
In any event, Americans pride themselves
on the efficiency of their stock market and other capital markets, which
enable vast numbers of sellers and buyers to engage in millions of
transactions each day. These markets owe their success in part to
computers, but they also depend on tradition and trust -- the trust of
one broker for another, and the trust of both in the good faith of the
customers they represent to deliver securities after a sale or to pay
for purchases. Occasionally, this trust is abused. But during the last
half century, the federal government has played an increasingly
important role in ensuring honest and equitable dealing. As a result,
markets have thrived as continuing sources of investment funds that keep
the economy growing and as devices for letting many Americans share in
the nation's wealth.
To work effectively, markets require the
free flow of information. Without it, investors cannot keep abreast of
developments or gauge, to the best of their ability, the true value of
stocks. Numerous sources of information enable investors to follow the
fortunes of the market daily, hourly, or even minute-by-minute.
Companies are required by law to issue quarterly earnings reports, more
elaborate annual reports, and proxy statments to tell stockholders how
they are doing. In addition, investors can read the market pages of
daily newspapers to find out the price at which particular stocks were
traded during the previous trading session. They can review a variety of
indexes that measure the overall pace of market activity; the most
notable of these is the Dow Jones Industrial Average (DJIA), which
tracks 30 prominent stocks. Investors also can turn to magazines and
newsletters devoted to analyzing particular stocks and markets. Certain
cable television programs provide a constant flow of news about
movements in stock prices. And now, investors can use the Internet to
get up-to-the-minute information about individual stocks and even to
arrange stock transactions.
The Stock Exchanges
There are thousands of stocks, but shares of the largest, best-known,
and most actively traded corporations generally are listed on the New
York Stock Exchange (NYSE). The exchange dates its origin back to 1792,
when a group of stockbrokers gathered under a buttonwood tree on Wall
Street in New York City to make some rules to govern stock buying and
selling. By the late 1990s, the NYSE listed some 3,600 different stocks.
The exchange has 1,366 members, or "seats," which are bought
by brokerage houses at hefty prices and are used for buying and selling
stocks for the public. Information travels electronically between
brokerage offices and the exchange, which requires 200 miles (320
kilometers) of fiber-optic cable and 8,000 phone connections to handle
quotes and orders.
How are stocks traded? Suppose a
schoolteacher in California wants to take an ocean cruise. To finance
the trip, she decides to sell 100 shares of stock she owns in General
Motors Corporation. So she calls her broker and directs him to sell the
shares at the best price he can get. At the same time, an engineer in
Florida decides to use some of his savings to buy 100 GM shares, so he
calls his broker and places a "buy" order for 100 shares at
the market price. Both brokers wire their orders to the NYSE, where
their representatives negotiate the transaction. All this can occur in
less than a minute. In the end, the schoolteacher gets her cash and the
engineer gets his stock, and both pay their brokers a commission. The
transaction, like all others handled on the exchange, is carried out in
public, and the results are sent electronically to every brokerage
office in the nation.
Stock exchange "specialists"
play a crucial role in the process, helping to keep an orderly market by
deftly matching buy and sell orders. If necessary, specialists buy or
sell stock themselves when there is a paucity of either buyers or
The smaller American Stock Exchange, which
lists numerous energy industry-related stocks, operates in much the same
way and is located in the same Wall Street area as the New York
exchange. Other large U.S. cities host smaller, regional stock
The largest number of different stocks and
bonds traded are traded on the National Association of Securities
Dealers Automated Quotation system, or Nasdaq. This so-called
over-the-counter exchange, which handles trading in about 5,240 stocks,
is not located in any one place; rather, it is an electronic
communications network of stock and bond dealers. The National
Association of Securities Dealers, which oversees the over-the-counter
market, has the power to expel companies or dealers that it determines
are dishonest or insolvent. Because many of the stocks traded in this
market are from smaller and less stable companies, the Nasdaq is
considered a riskier market than either of the major stock exchanges.
But it offers many opportunities for investors. By the 1990s, many of
the fastest growing high-technology stocks were traded on the Nasdaq.
A Nation of Investors
An unprecedented boom in the stock market, combined with the ease of
investing in stocks, led to a sharp increase in public participation in
securities markets during the 1990s. The annual trading volume on the
New York Stock Exchange, or "Big Board," soared from 11,400
million shares in 1980 to 169,000 million shares in 1998. Between 1989
and 1995, the portion of all U.S. households owning stocks, directly or
through intermediaries like pension funds, rose from 31 percent to 41
Public participation in the market has
been greatly facilitated by mutual funds, which collect money from
individuals and invest it on their behalf in varied portfolios of
stocks. Mutual funds enable small investors, who may not feel qualified
or have the time to choose among thousands of individual stocks, to have
their money invested by professionals. And because mutual funds hold
diversified groups of stocks, they shelter investors somewhat from the
sharp swings that can occur in the value of individual shares.
There are dozens of kinds of mutual funds,
each designed to meet the needs and preferences of different kinds of
investors. Some funds seek to realize current income, while others aim
for long-term capital appreciation. Some invest conservatively, while
others take bigger chances in hopes of realizing greater gains. Some
deal only with stocks of specific industries or stocks of foreign
companies, and others pursue varying market strategies. Overall, the
number of funds jumped from 524 in 1980 to 7,300 by late 1998.
Attracted by healthy returns and the wide
array of choices, Americans invested substantial sums in mutual funds
during the 1980s and 1990s. At the end of the 1990s, they held $5.4
trillion in mutual funds, and the portion of U.S. households holding
mutual fund shares had increased to 37 percent in 1997 from 6 percent in
How Stock Prices Are Determined
Stock prices are set by a combination of factors that no analyst can
consistently understand or predict. In general, economists say, they
reflect the long-term earnings potential of companies. Investors are
attracted to stocks of companies they expect will earn substantial
profits in the future; because many people wish to buy stocks of such
companies, prices of these stocks tend to rise. On the other hand,
investors are reluctant to purchase stocks of companies that face bleak
earnings prospects; because fewer people wish to buy and more wish to
sell these stocks, prices fall.
When deciding whether to purchase or sell
stocks, investors consider the general business climate and outlook, the
financial condition and prospects of the individual companies in which
they are considering investing, and whether stock prices relative to
earnings already are above or below traditional norms. Interest rate
trends also influence stock prices significantly. Rising interest rates
tend to depress stock prices -- partly because they can foreshadow a
general slowdown in economic activity and corporate profits, and partly
because they lure investors out of the stock market and into new issues
of interest-bearing investments. Falling rates, conversely, often lead
to higher stock prices, both because they suggest easier borrowing and
faster growth, and because they make new interest-paying investments
less attractive to investors.
A number of other factors complicate
matters, however. For one thing, investors generally buy stocks
according to their expectations about the unpredictable future, not
according to current earnings. Expectations can be influenced by a
variety of factors, many of them not necessarily rational or justified.
As a result, the short-term connection between prices and earnings can
Momentum also can distort stock prices.
Rising prices typically woo more buyers into the market, and the
increased demand, in turn, drives prices higher still. Speculators often
add to this upward pressure by purchasing shares in the expectation they
will be able to sell them later to other buyers at even higher prices.
Analysts describe a continuous rise in stock prices as a
"bull" market. When speculative fever can no longer be
sustained, prices start to fall. If enough investors become worried
about falling prices, they may rush to sell their shares, adding to
downward momentum. This is called a "bear" market.
During most of the 20th century, investors could earn more by
investing in stocks than in other types of financial investments --
provided they were willing to hold stocks for the long term.
In the short term, stock prices can be
quite volatile, and impatient investors who sell during periods of
market decline easily can suffer losses. Peter Lynch, a renowned former
manager of one of America's largest stock mutual funds, noted in 1998,
for instance, that U.S. stocks had lost value in 20 of the previous 72
years. According to Lynch, investors had to wait 15 years after the
stock market crash of 1929 to see their holdings regain their lost
value. But people who held their stock 20 years or more never lost
money. In an analysis prepared for the U.S. Congress, the federal
government's General Accounting Office said that in the worst 20-year
period since 1926, stock prices increased 3 percent. In the best two
decades, they rose 17 percent. By contrast, 20-year bond returns, a
common investment alternative to stocks, ranged between 1 percent and 10
Economists conclude from analyses like
these that small investors fare best if they can put their money into a
diversified portfolio of stocks and hold them for the long term. But
some investors are willing to take risks in hopes of realizing bigger
gains in the short term. And they have devised a number of strategies
for doing this.
Buying on Margin. Americans buy
many things on credit, and stocks are no exception. Investors who
qualify can buy "on margin," making a stock purchase by paying
50 percent down and getting a loan from their brokers for the remainder.
If the price of stock bought on margin rises, these investors can sell
the stock, repay their brokers the borrowed amount plus interest and
commissions, and still make a profit. If the price goes down, however,
brokers issue "margin calls," forcing the investors to pay
additional money into their accounts so that their loans still equal no
more than half of the value of the stock. If an owner cannot produce
cash, the broker can sell some of the stock -- at the investor's loss --
to cover the debt.
Buying stock on margin is one kind of
leveraged trading. It gives speculators -- traders willing to gamble on
high-risk situations -- a chance to buy more shares. If their investment
decisions are correct, speculators can make a greater profit, but if
they are misjudge the market, they can suffer bigger losses.
The Federal Reserve Board (frequently
called"the Fed"), the U.S. government's central bank, sets the
minimum margin requirements specifying how much cash investors must put
down when they buy stock. The Fed can vary margins. If it wishes to
stimulate the market, it can set low margins. If it sees a need to curb
speculative enthusiasm, it sets high margins. In some years, the Fed has
required a full 100 percent payment, but for much of the time during the
last decades of the 20th century, it left the margin rate at 50 percent.
Selling Short. Another group of
speculators are known as "short sellers." They expect the
price of a particular stock to fall, so they sell shares borrowed from
their broker, hoping to profit by replacing the stocks later with shares
purchased on the open market at a lower price. While this approach
offers an opportunity for gains in a bear market, it is one of the
riskiest ways to trade stocks. If a short seller guesses wrong, the
price of stock he or she has sold short may rise sharply, hitting the
investor with large losses.
Options. Another way to leverage a
relatively small outlay of cash is to buy "call" options to
purchase a particular stock later at close to its current price. If the
market price rises, the trader can exercise the option, making a big
profit by then selling the shares at the higher market price
(alternatively, the trader can sell the option itself, which will have
risen in value as the price of the underlying stock has gone up). An
option to sell stock, called a "put" option, works in the
opposite direction, committing the trader to sell a particular stock
later at close to its current price. Much like short selling, put
options enable traders to profit from a declining market. But investors
also can lose a lot of money if stock prices do not move as they hope.
Commodities and Other Futures
Commodity "futures" are contracts to buy or sell certain
certain goods at set prices at a predetermined time in the future.
Futures traditionally have been linked to commodities such as wheat,
livestock, copper, and gold, but in recent years growing amounts of
futures also have been tied to foreign currencies or other financial
assets as well. They are traded on about a dozen commodity exchanges in
the United States, the most prominent of which include the Chicago Board
of Trade, the Chicago Mercantile Exchange, and several exchanges in New
York City. Chicago is the historic center of America's agriculture-based
industries. Overall, futures activity rose to 417 million contracts in
1997, from 261 million in 1991.
Commodities traders fall into two broad
categories: hedgers and speculators. Hedgers are business firms,
farmers, or individuals that enter into commodity contracts to be
assured access to a commodity, or the ability to sell it, at a
guaranteed price. They use futures to protect themselves against
unanticipated fluctuations in the commodity's price. Thousands of
individuals, willing to absorb that risk, trade in commodity futures as
speculators. They are lured to commodity trading by the prospect of
making huge profits on small margins (futures contracts, like many
stocks, are traded on margin, typically as low as 10 to 20 percent on
the value of the contract).
Speculating in commodity futures is not
for people who are averse to risk. Unforeseen forces like weather can
affect supply and demand, and send commodity prices up or down very
rapidly, creating great profits or losses. While professional traders
who are well versed in the futures market are most likely to gain in
futures trading, it is estimated that as many as 90 percent of small
futures traders lose money in this volatile market.
Commodity futures are a form of
"derivative" -- complex instruments for financial speculation
linked to underlying assets. Derivatives proliferated in the 1990s to
cover a wide range of assets, including mortgages and interest rates.
This growing trade caught the attention of regulators and members of
Congress after some banks, securities firms, and wealthy individuals
suffered big losses on financially distressed, highly leveraged funds
that bought derivatives, and in some cases avoided regulatory scrutiny
by registering outside the United States.
The Securities and Exchange Commission (SEC), which was created in
1934, is the principal regulator of securities markets in the United
States. Before 1929, individual states regulated securities activities.
But the stock market crash of 1929, which triggered the Great
Depression, showed that arrangement to be inadequate. The Securities Act
of 1933 and the Securities Exchange Act of 1934 consequently gave the
federal government a preeminent role in protecting small investors from
fraud and making it easier for them to understand companies' financial
The commission enforces a web of rules to
achieve that goal. Companies issuing stocks, bonds, and other securities
must file detailed financial registration statements, which are made
available to the public. The SEC determines whether these disclosures
are full and fair so that investors can make well-informed and realistic
evaluations of various securities. The SEC also oversees trading in
stocks and administers rules designed to prevent price manipulation; to
that end, brokers and dealers in the over-the-counter market and the
stock exchanges must register with the SEC. In addition, the commission
requires companies to tell the public when their own officers buy or
sell shares of their stock; the commission believes that these
"insiders" possess intimate information about their companies
and that their trades can indicate to other investors their degree of
confidence in their companies' future.
The agency also seeks to prevent insiders
from trading in stock based on information that has not yet become
public. In the late 1980s, the SEC began to focus not just on officers
and directors but on insider trades by lower-level employees or even
outsiders like lawyers who may have access to important information
about a company before it becomes public.
The SEC has five commissioners who are
appointed by the president. No more than three can be members of the
same political party; the five-year term of one of the commissioners
expires each year.
The Commodity Futures Trading Commission
oversees the futures markets. It is particularly zealous in cracking
down on many over-the-counter futures transactions, usually confining
approved trading to the exchanges. But in general, it is considered a
more gentle regulator than the SEC. In 1996, for example, it approved a
record 92 new kinds of futures and farm commodity options contracts.
From time to time, an especially aggressive SEC chairman asserts a
vigorous role for that commission in regulating futures business.
"Black Monday" and the Long Bull Market
On Monday, October 19, 1987, the value of stocks plummeted on markets
around the world. The Dow Jones Industrial Average fell 22 percent to
close at 1738.42, the largest one-day decline since 1914, eclipsing even
the famous October 1929 market crash.
The Brady Commission (a presidential
commission set up to investigate the fall) the SEC, and others blamed
various factors for the 1987 debacle -- including a negative turn in
investor psychology, investors' concerns about the federal government
budget deficit and foreign trade deficit, a failure of specialists on
the New York Stock Exchange to discharge their duty as buyers of last
resort, and "program trading" in which computers are
programmed to launch buying or selling of large volumes of stock when
certain market triggers occur. The stock exchange subsequently initiated
safeguards. It said it would restrict program trading whenever the Dow
Jones Industrial Average rose or fell 50 points in a single day, and it
created a "circuit-breaker" mechanism to halt all trading
temporarily any time the DJIA dropped 250 points. Those emergency
mechanisms were later substantially adjusted to reflect the large rise
in the DJIA level. In late 1998, one change required program-trading
curbs whenever the DJIA rose or fell 2 percent in one day from a certain
average recent close; in late 1999, this formula meant that program
trading would be halted by a market change of about 210 points. The new
rules set also a higher threshold for halting all trading; during the
fourth quarter of 1999, that would occur if there was at least a
1,050-point DJIA drop.
Those reforms may have helped restore
confidence, but a strong performance by the economy may have been even
more important. Unlike its performance in 1929, the Federal Reserve made
it clear it would ease credit conditions to ensure that investors could
meet their margin calls and could continue operating. Partly as a
result, the crash of 1987 was quickly erased as the market surged to new
highs. In the early 1990s, the Dow Jones Industrial Average topped
3,000, and in 1999 it topped the 11,000 mark. What's more, the volume of
trading rose enormously. While trading of 5 million shares was
considered a hectic day on the New York Stock Exchange in the 1960s,
more than a thousand-million shares were exchanged on some days in 1997
and 1998. On the Nasdaq, such share days were routine by 1998.
Much of the increased activity was
generated by so-called day traders who would typically buy and sell the
same stock several times in one day, hoping to make quick profits on
short-term swings. These traders were among the growing legions of
persons using the Internet to do their trading. In early 1999, 13
percent of all stock trades by individuals and 25 percent of individual
transactions in securities of all kinds were occurring over the
With the greater volume came greater
volatility. Swings of more than 100 points a day occurred with
increasing frequency, and the circuit-breaker mechanism was triggered on
October 27, 1997, when the Dow Jones Industrial Average fell 554.26
points. Another big fall -- 512.61 points -- occurred on August 31,
1998. But by then, the market had climbed so high that the declines
amounted to only about 7 percent of the overall value of stocks, and
investors stayed in the market, which quickly rebounded.
Source: U.S. Department of State