WHAT MAKES THE STOCK MARKET GO UP--AND DOWN

FROM its inception, the stock market was meant to be a place where businessmen could raise capital by selling shares in their enterprises, and where investors could turn a profit when those enterprises prospered. The market still serves both purposes, but today it is judged less by what it does for businessmen seeking capital than by what it accomplishes for investors seeking gain.

In a time of high and rising taxes, investment in stocks is one of the few ways by which a wage or salary earner can hope to become rich--at least on paper. As a result, the number of Americans who own shares has risen to 24 million. An estimated 76 million others own stock indirectly through their holdings in pension funds and the like. Now that the market has become the prime source of a second income for many Americans, they are increasingly asking a puzzling question: What makes the market go up--and down?

With so many people and so much money involved in investments, the market is inevitably fluttered by politics at home and alarms abroad, by racy tips and wild rumors that whisper along Wall Street. No matter that the rumors usually have the reliability quotient of the market-rallying report two weeks ago that the Pueblo was about to be released by North Korea. That word apparently came from Red China by way of Paris. Last week the market fell and then rebounded in a swirl of contradictory reports that President Johnson was (or was not) planning to call for wartime controls on the economy, that profits were (or were not) heading up.

The New Managers

In many cases, such "inside" information reflects a broker's rationalization, a story confected for customers to account for a swing in paper profits. Or it follows a line laid down by overnight experts--financial writers required to fill columns of type with solemn economic logic to explain short-term market moves that may reflect neither economics nor logic. Too often, day-to-day stock gyrations obscure a basic fact: markets are made and moved over the long haul, not by vague forces but by the conscious decisions of men. The important question is not what makes stocks move--but who.

The most powerful men in the market are the managers of the fastest-growing pools of investment capital--the mutual funds, profit-sharing funds, and corporate-and union-pension funds. To a surprising degree, the institutional managers are men in their 30s and early 40s, and they are changing many of the old rules with new attitudes. Instead of aiming to preserve capital or achieve steady dividends, they are confidently committed to a cult of growth. In their search for short-term gain, many are taking longer risks for larger profits, trading in and out for the quick turn.

They are a world removed from the robber barons of the '20s, who manipulated markets for their own gain. But while their motives are proper enough, and their actions usually beneficial, Federal Reserve Chairman William McChesney Martin, the apolitical conscience of the nation's economy, has warned that the managers of the institutions wield a potentially dangerous amount of market influence.

That influence is rapidly expanding. Institutional investors now account for at least 35% of the trading on the New York Stock Exchange, and the proportion will be up to 50% by the mid-1970s. From 1955 through 1966--the latest date for which totals are available--the market value of stocks owned by institutions rose tremendously: from $9 billion to $19 billion for insurance companies, $12 billion to $37 billion for mutual funds, and from $6 billion to $38 billion for pension funds.

These hoards of investment capital have been a major factor in sending prices up because they have created a demand for stock that is growing much faster than the supply of shares. Largely because capital-seeking companies now get a better tax break by issuing bonds instead of stock, the amount of newly issued shares dropped from $5.2 billion in 1957 to $1.5 billion in 1967 (when $16 billion in bonds were floated).

Companies that once refused to risk their pension funds in common stocks have changed their policies with a vengeance; they now spread their funds among the trust departments of several banks, setting up a competition to see which can "perform" the most profitably. Instead of managing those portfolios through large and cautious investment committees, banks now tend to put them under a single manager. And instead of channeling their funds into several hundred stocks, the managers tend to concentrate them in several dozen issues on which they can keep a close watch.

Probably the largest accumulation of investment capital is held by Manhattan's Morgan Guaranty Trust Co., a lineal descendant of J. P. Morgan & Co. By the best estimates, it administers 250 pension funds with assets totaling about $7 billion. All its stock trading decisions are initiated by one man: Carl Hathaway, 34, a Harvard graduate. He weighs the recommendations of the bank's analysts, makes his choices, and then presents them to a small group of senior officers--who almost always go along with his advice. Morgan has concentrated one-third of its equity investments in just ten stocks, the names of which are a well-guarded secret. Hathaway and men like him are not averse to selling any stocks that fail to do as well as expected. Some institutional managers figure that if money goes up 100% in one stock, it does not rise as much as if they had bought five stocks successively and sold each one when it advanced 20%. Had they done the latter, they would be starting from a bigger base each time, and the money would appreciate 154%.*

The Big Rise

Managers of mutual funds and, to a lesser degree, pension funds are operating so exuberantly that in this year's first month volume rose 62% on the American Stock Exchange and went up 20% on the New York Stock Exchange. Trouble is, the exchanges and the back offices of brokerage firms have not expanded and automated fast enough to keep up with the increase. In the resulting snarl of tape and paper, countless buyers have either received the wrong confirmation slips and stock certificates or failed to receive any at all. As they struggle to straighten out the mess, brokers earning upward of $50,000 a year have had to spend as much time doing the work of $80-a-week stock clerks as they do studying the stocks they sell so profitably. For the past two weeks, the market has had to close early to give brokers a chance to restore some order.

The root problem is that the market is still locked to the 18th century practice of shuffling millions of paper stock certificates back and forth among investors. What market managers need, and are trying to achieve, is a completely automated system that would do away with the fancy certificates but record the transactions of every investor on a master file, like deposits and withdrawals in bank accounts.

Inevitably, the upsurge in trading has led to some sharprises, often followed by precipitous falls, in the shares of relatively small companies that have more promise than profit. But there is no doubt that most institutions have earned much more than they would have if they had invested only in bonds or blue-chip stocks. Last year one-third of the nation's major mutual funds gained 33% or more, and several rose better than 100%.

During the past year, of course, it took bad judgment, bad timing and bad luck to lose money in the market. The Dow-Jones industrial average of 30 basic blue chips rose 15% in 1967, but the Dow is much too narrow a gauge. Outmoded and inadequate, it does not come close to measuring the total market or its most dynamic companies, even though it has an exaggerated influence over the market's mood. It closed last week at 864--just about where it was three years ago. The better, broader Standard & Poor index of 500 of the 1,255 common stocks on the New York Exchange rose 20% last year, and even that figure tells only a modest part of the story. Shares on the American Exchange jumped 82% in 1967, and the Standard & Poor average of 20 low-priced issues climbed 87%. While few experts expect such phenomenal growth to continue, in an expansive economy the long-term trend remains bullish.

How They Pick Them

As they search for promising shares, the professionals look above all for corporate profits--but there has been a change in the kind of profits that they seek. Today's stock analysts are much less interested in past or even present profits than the potential for future growth. Many are largely uninterested in a company's physical assets because some of the best earnings gainers, especially in service industries, have little in the way of property or machines.

Analysts are most concerned about a stock's price-earnings ratio--that is, its price relative to earnings per share expected in the current year. Professionals tend to assign rather low P-E ratios to companies with profits that are rising only as fast as the U.S. economy's gross national product. Thus, the Dow-Jones industrials now have P-E ratios averaging less than 17 to 1, down from 21 to 1 just before the 1962 market break. Analysts give much more generous P-Es--50 to 1, or more--to companies with profits that rise faster than the U.S. economy and, most significantly, look as if they will continue to do so.

In the chart-covered offices of banks, brokerages and mutual funds, computers constantly scan the stock lists to spot companies or entire industries that appear to be breaking out of their usual earnings pattern. Once an uptrend is noted, word quickly gets around; analysts go to the same meetings, tend to eat at the same places. They constantly talk with each other on local or long-distance phones. Brokerage houses also pass on their research findings to mutual funds and other institutions in hope of landing their enormous commission business. Says an officer of one Boston-based mutual fund: "A stock often starts to move when an analyst builds up a good story about it. If you are being told a good story and you think you are near the top of the list of those being told, you buy because you know that the story will be told to others, and the stock will go up."

Like clothes and art, stocks are also subject to fads, fashions and fancies. There was a big play in uranium shares in the 1940s, in utilities in the 1950s, in airlines early in the 1960s. Last year fashion focused on computer leasing and computer-software manufacturers, supplemental air carriers, electronics and office-equipment firms. Some of them quadrupled and quintupled in price within a few months. Now most of them have calmed down, and new vogues may be beginning. But how is the individual investor to know what those vogues will be? Though there is no sure answer, most people find that it pays to shop around for a sympathetic and knowing broker. At the very least, he can be expected to know what other brokers are buying and selling.

That knowledge is important, for along with the large institutions, some relatively small brokers often come close to controlling markets in the stocks of small but "glamorous" companies. It is no trick these days for a broker to have $20 million in buying power. If he is attracted to a company that has few shares outstanding, induces his customers to buy the stock, and puts only 5% ($1,000,000) of his buying power into it, the demand is likely to drive the stock up simply because its supply is so limited. Many brokers tend to favor lower-priced issues because they carry higher commissions. Quite a few also like to find a "hot" industry and then recommend one of the most depressed companies in the field. Explains one top broker: "In a good industry, with profits going up quarter by quarter, even the garbage is going to go through the roof. If you want to make the biggest gain, you pick the most marginal company."

Since the market is made up of millions of individual investors, people who try to describe it often talk as if it has a character or personality of its own--which, in effect, it has. The market knows what it likes and what it doesn't like. It prefers higher taxes to tighter money, because the latter tends to draw funds out of stocks into higher-yielding, fixed-income investments--which is what happened late in 1966. When President Johnson--whose every major pronouncement causes the market to react, and often to overreact--called for a surtax early in 1967, he helped the market to spurt. Professionals figured that if taxes rose as an anti-inflationary measure, the Federal Reserve's Chairman Martin could loosen up a bit on money and interest rates. But the market went down whenever opposition to the surtax was voiced by Congressman Wilbur Mills, the House Ways and Means Committee chairman, whose power over economic legislation gives him an influence over the market that ranks just behind that of Johnson and Martin.

Contrary to common belief, the market is not enthusiastic about inflation because it tends to erode real profits and bring tight money and Government controls. The market hates the thought of controls on credit, wages and prices. More than anything else, the market abhors uncertainty, even though it is risk, speculation and uncertainty that make markets go.

Trying to outguess that uncertainty can be particularly frustrating to small investors. Why, for example, when a company announces higher earnings, does its stock so often go down? In their jargon, brokers and analysts say that they have already "discounted" the news--meaning that they anticipated it and "sold on the news." An investor might also think that market averages will fall when other small investors sell more stock than they buy. In fact, markets often go up because professionals figure that small "odd-lotters" overreact and are generally wrong.

Thus, one of the large factors in the market is people's judgment of other people. Markets react to what amateurs think the professionals will do, and to what professionals think the amateurs will do. Which means that the value of a company's shares often depends less on their real worth than on what some people think that other people will pay for them.

Psychology & Fundamentals

The small investor, even more than the professional, tends to respond to that intangible, unpredictable but all-important factor: market psychology. When an up-or downtrend begins, market psychology often exaggerates it. In the latter half of 1966, when the market began to plunge, many investors sold out on the theory that things would get worse. Market averages dropped, and many glamour stocks were whacked in half. Within three months, after many small investors had sold out at the bottom, the market bounced back. Now much the same thing appears to be happening again. Stocks have dropped about 4% on average thus far this year.

The situation today is just about the same as during the late 1966 decline and the early 1967 rise: there are uncertainties about military and monetary problems abroad, about inflation and taxes and urban problems at home. And the economy continues to climb. As the market responds to tips and touts with short-term flutters, it continues to perform over the longer term with a certain consistency. If history is any guide, stocks will rise and fall along with three fundamental factors: 1) the overall health of the economy, 2) the state of corporate profits, and 3) the availability and cost of money. Investors who have faith that the nation will continue to prosper still feel comfortable about the future of common stocks.

* High-income individuals would not do quite so well because they would have to pay income taxes on their short-term profits. Mutual funds pay taxes, but most pension funds and profit-sharing funds do not. Their members pay capital-gains taxes on their profits, but only when they collect their share of the funds.

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