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Remember When The Markets Made Sense?


Economic Viewpoint

REMEMBER WHEN THE MARKETS MADE SENSE?

Economists are supposed to believe in markets. I do. Those who question the prices determined in markets risk expulsion from the clan. Nonetheless, here is my confession: The older I get, the less respect I have for the signals emitted by our vaunted speculative markets. Sometimes, they are downright ludicrous.

Please note that this does not mean that the markets are unimportant. Some of them, in fact, have profound effects on the economy. Nor does it necessarily mean that the government should regulate the markets more tightly. Nor, most especially, does it mean that I have figured out how to "beat" the markets. On the contrary, I find them more enigmatic every year.

What I do mean is that speculative markets seem increasingly to have lost touch with economic fundamentals and developed a life of their own, quite independent of any other reality. Understanding economics is of little apparent use in deciphering these markets--and may even be a hindrance.

For example: Crude oil has become a speculative commodity in recent decades. The futures market, which prices oil minute by minute, is active, global, and often tumultuous. Fundamentals of supply and demand tell us that the invasion of Kuwait in August, 1990, should have driven up crude prices, and so it did. But in the months following the invasion, oil prices soared to levels that strained (or, in my case, broke) credulity--as high as $40 a barrel. What conceivable scenario could have justified such a price?

EUPHORIA. Believers in the wisdom of markets had a ready answer: The market was worried that a major shooting war might engulf the Saudi oil fields in flames or otherwise disrupt Middle East oil shipments. I was willing to accept the market's estimate of the likelihood of war over my own. After all, what do I know about warfare and geopolitics? But how likely was it that the Iraqi war machine--that oxymoron of 1991--could close down oil fields protected by the armed might of the U. S.? That event had to be pretty likely to rationalize the observed $40 price. For example, suppose the market believed that oil would cost $25 per barrel if the guns stayed silent, but $60 per barrel if a major shooting war erupted. Then, to account for a market price of $40, "the market" had to believe that the probability of a war large enough to impede the flow of oil seriously was 43%! Could anyone ever have believed that?

Well, suppose the market did. Then how do you explain the financial euphoria that greeted the outbreak of hostilities on Jan. 16? If oil at $40 a barrel was based on fears of a shooting war, the stock market should have tumbled as the price of oil soared when war broke out. Foolishly sticking to fundamentals, that is precisely what I expected. Instead, stocks rocketed as soon as the market opened on Jan. 17, and the price of oil tumbled from $32 to $21.45 in one day.

CRAZY REACTION. Friends who watch markets closely assured me that traders acquired information in the opening hours of the war that made them more optimistic. What information, I asked? I had been glued to Cable News Network, too, and it appeared that the only thing we had learned was that the dread shooting war had become a reality.

Their answer? The market had learned that America would control the air--a reply that reminded me of the old song, Is That All There Is? Did anyone ever imagine that the allies would not control the air? In those opening hours of war, we learned nothing about the fighting ability, or lack thereof, of Iraq's ground forces, and hence next to nothing about whether oil supplies might be interrupted. Yet the market reacted as if the threat of a serious disruption had suddenly been lifted. Crazy. It reminded me of the legendary headline about the foreign-exchange market: "Dollar soars on no news."

Finally, on Feb. 23, the markets got some real news to digest: A large-scale land war had erupted. Expert opinion had previously been divided on whether there would be a land war and, if so, how tough the fight would be. Within minutes, the first question was answered; within a day or two, the second was, too. Yet the markets' reaction was surprisingly muted. Neither the stock market nor the oil market celebrated the victory.

Had the markets, in their wisdom, anticipated such an easy outcome? If so, I am deeply impressed. The more likely explanation, however, is that oil-market fundamentals have had precious little influence on the prices of either oil or stocks from Aug. 2 until today.

My final example comes from the bond market. A few weeks ago, a weak employment report induced the Federal Reserve Board to push short-term interest rates down another notch--apparently because that worsened its view of the economic outlook. Deeper recessions spell more disinflation; lower inflation is good for bonds. These, I know, are fundamentals. Yet the bond market fell on the news. Why? According to the media, the market was worried that the Fed had eased too much--which would be inflationary!

Either the media or the market should have its head examined. Probably both.ALAN S. BLINDER


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