How the U.S. Economy Works

The U.S. Economy:
A Brief History

Small Business and the Corporation

Stocks, Commodities, and Markets

The Role of the Government in the Economy

Monetary and Fiscal Policy

American Agriculture:
Its Changing Significance

Labor in America:
The Worker's Role

Foreign Trade and Global Economic Policies

Afterword:
Beyond Economics

Glossary

  Stocks,
Commodities,
       and
    Markets

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 sellers.
     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 exchanges.
     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 percent.
     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 1979.

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 be tenuous.
     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.

Market Strategies
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 percent.
     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.