Today's Market Is Different,
But So Are Risks to Investors

By SUZANNE MCGEE
Staff Reporter of THE WALL STREET JOURNAL

Monday marks the 10th anniversary of the stock market's peak before it began its slow slide toward Black Monday, the day on Oct. 19, 1987, that the Dow Jones Industrial Average plunged a record 23%.

These days, the market seems to be a much more benign beast than it was a decade ago.

Analysts cite all sorts of reasons they don't expect another huge sell-off to be imminent: Inflation is tame or nonexistent, interest rates are relatively low, the economy is perking along nicely and corporate earnings continue to provide pleasant surprises.

"You don't have any inflation, you have favorable monetary policy, tremendous liquidity and the market's shown an unbelievable resilience in bouncing back from sell-offs," says Jack Baker, head of stock trading at Furman Selz. "There's a whole big laundry list of positive things out there."

But while conditions in the economy and the stock market are very different today than they were 10 years ago, the worrywarts among stock-market watchers put forth this warning: Whatever eventually touches off the next market retreat of any consequence is most likely going to be different, too.

Expecting the Unexpected

Even bulls like Mr. Baker were willing to acknowledge that something unexpected could derail this utopian environment, but he says it is hard to see what that might be.

"A Middle Eastern war?" he muses. "There's always the caveat that something unexpected from the outside could change everything, but of course, the nature of the unexpected is you've no idea what it is or when it will hit."

"The market is looking for signs of similar risks, like higher rates," says Claude Amadeo, senior research associate at Bridgewater Associates, a Wilton, Conn.-based research firm. "But there are a lot of new risks around right now that people aren't even thinking about."

One of biggest new risks, he says, is the tendency among investors to conclude, after years of above-average stock market returns without a sizable correction, that it really is "different this time."

One of the fiercest stock-market debates is over whether the economy has indeed entered a "new era," or whether earnings growth, valuations and returns on stocks are about to revert to historical averages.

"The riskiest thing I hear is people throwing away valuation models because they haven't worked in the last few years," Mr. Amadeo says. "It's just as bad to assume nothing traditional works as it is to assume that because interest rates aren't soaring, we're in no danger of a 1987-style sell-off."

Mutual Funds Multiply

One of the market's biggest changes is the proliferation of mutual funds. Before the crash, 812 mutual funds managed $241.9 billion in assets. Today, that figure has mushroomed to 2,855 funds controlling a whopping $2.13 trillion, according to the Investment Company Institute.

In ICI surveys, some two-thirds of mutual-fund investors made their first purchase before the 1990 stock-market decline, while another two-thirds contend that a 15% stock-market decline over the next three months wouldn't turn them into sellers.

But not everyone is convinced that fund investors won't bolt for the exits if a sell-off doesn't lead promptly to a rebound.

"There are more novice investors today, and novice investors are price-sensitive," says Robert Farrell, senior investment officer at Merrill Lynch. He notes that after small stocks took a hit earlier this year, "you saw a lot of redemptions in small-stock mutual funds."

Changed Strategies

Money managers' strategies also have changed over the past decade. Indexed investing, or managing a portfolio designed to replicate the Standard & Poor's 500-stock index or other benchmark, has boomed in popularity: The Vanguard S&P 500 index fund, ranked the 90th-largest stock fund in 1987 by Morningstar, is now the second-largest mutual fund of any kind.

Indexing has helped push the largest stocks up the most in recent years. But critics argue that what goes up fast can come down fast if investors panic. And program trading, which has boomed along with indexing, has increased the market's tendency to move sharply in a single direction, analysts say.

In 1987, portfolio insurance-an effort to ensure that stock-market gains would be protected in the event of a sell-off-backfired during the crash when its vendors tried to hedge their own exposure to the falling market by selling index futures as the market fell. That selling was cited as a major contributor to Black Monday.

While old-style portfolio insurance is gone, investors still can use a myriad of over-the-counter options products designed by Wall Street investment dealers to lock in their gains and hedge their risks. It is impossible to determine the total volume of these positions or their potential impact on the market in a sell-off if investors or dealers try to sell into a falling market.

"I see there being a chance that we could have the same kind of accelerating declines as we did with portfolio insurance," argues Merrill's Mr. Farrell.

Momentum Investors

The proliferation of momentum investors, who move swiftly into and back out of stocks with little concern for fundamentals, worries Gary Brinson, whose Chicago-based Brinson Partners has $131 billion under management.

"Over time, you're running the risk that a whole lot of these triggers would be pulled, and you'd see cascade after cascade of selling," he says.

Technological changes also will play a role in this, market analysts argue. While bulls like Furman Selz's Mr. Baker argue that easy access to stock information on television or over the Internet helps educate individual investors, some cautious analysts fret that investors will respond more quickly, with less reflection, to any shock to the market's fundamentals.

Only a major market setback will prove who's right, and bulls and bears agree on two things: that the trigger for such a sell-off is likely to be something no one can foresee today, and that the market's downward path is likely to be less steep, thanks to a range of trading curbs. Those trading restrictions imposed by the New York Stock Exchange make a one-day cataclysm like Black Monday improbable.

And even the optimists acknowledge that the stock market's high returns in the past few years imply a relatively high level of risk that most investors are ignoring. That suggests, they say, that at some point the returns will fall, either suddenly or quickly.

"It doesn't matter what causes a sell-off," says Greg Smith, Prudential Securities' investment strategist. "It could be a surge in speculative activity, a slowdown in consumer spending, the year 2000 problem in computers. But someday, something is going to scare investors once again."

Making Comparisons

A before and after look at the markets and economy

The Markets

The Economy

(1) First-half average
(2) Through July
(3) July 1987
(4) July 1997
(5) Estimate
(6) Second quarter

Sources: Datastream Int'l, Congressional Budget Office, Bureau of Economic Analysis, Ned Davis Research. WSJ research

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