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What the stock "correction' corrects

Now that the post-1991 bull stock market has suffered its first major setback (defined in the trade as a drop of 10 percent or more), the time has come to ask: What does a Wall Street "correction" correct?

It corrects Wall Street, for one thing _ and the structure of the economy that Wall Street is in business to finance, for another. One-way markets are just as subversive to sound finance as one-party politics are to good government.

Over time, the faction in power begins to believe its own press. Heads swell and feet find their way to the tops of the factional desks. On Wall Street, the party in power _ the bull party _ has held undisputed control for 15 years.

Because stock prices have relentlessly risen, people have come to expect them to continue to rise, and the public has recalibrated its tolerance for risk.

Inasmuch as stock prices always rise, the thinking goes, there is really no risk. But there's always risk: An uncorrected bull market creates its own.

Monday's collapse in the value of the shares of Oxford Health Plans Inc. points up the perils of speculative traffic that flows at high speeds in a single direction. Oxford is a managed-care company that could do no wrong. It reported quarter after quarter of stupendous growth. Brokerage-house analysts called it a profit machine, and they outdid one another to recommend its shares.

To the bears' contentions that Oxford's accounting was questionable or that the doctors in some of the Oxford plans were going unpaid, the bulls could simply point to the rising track of the company's stock price.

Then, all of a sudden, the market took the bears' side. In a matter of hours on Monday, the stock _ so long caressed by the supposed financial professionals _ lost 62 percent of its value.

Such a delusion could last for as long as it did only in a market like this one.

William M. McGarr, a short-seller who has lost money just as steadily as the public has made it in recent years, says that Wall Street analysts have come to enjoy a kind of diplomatic immunity. Because the analysts are congenitally bullish, and because the market these last seven years has always risen, sloth has paid almost as well as hard work. To the bear party, so long out of power, it has been a vale of tears.

Of course, there is more at stake than the bank balances of the people (myself not least) who seem never to get the hang of the levitating 1990s. Sky-high stock prices and super-abundant credit have incited capital investment in the United States and Asia alike.

A huge expansion of manufacturing capacity is under way _ in chemicals, paper, aircraft and autos, among other things, the Wall Street Journal reported on Aug. 7. To this list I would add commercial banking and high technology.

Presented with the financial means to build the extra semiconductor fabricating plant or the marginal personal-computer manufacturing plant, the world's high-tech manufacturers have not hesitated. The result is a boom in productive capacity _ and a collapse in the prices of memory chips and personal computers, the most basic commodities of the information age.

Even Intel has lately been forced to cut the prices of its microprocessors. And the hottest new computers are the ones that sell for less than $1,000.

Consumers will cheer this fire sale, but the wise consumer-investor will spare a moment to reflect on it. It's the world's bull markets that have helped to elicit this cornucopia of new productive capacity. But the same bull markets have drawn their strength from the profitability (actual or imagined) of the companies whose stocks only seem to go up.

In the sense that too high prices create the itch to overinvest, and in the sense that overinvestment leads to falling profits, all bull markets are eventually self-limiting _ no matter what the Federal Reserve might do.

The foundation of any investment market is value. The more that stock prices outrun the earning power of the businesses that print their stock certificates, the less value there is. Conversely, the more that stock prices fall in relation to the earning power of the businesses that print their stock certificates, the more value there is.

The best news for investors these scary days and nights is that value is fast being restored to Asia. In South Korea, the Philippines and Japan, to name only three storm-damaged countries, more and more solvent operating businesses are being priced as if they were going out of business.

Sooner or later, however, the Asian correction will run its course. Only then will the bears be sent packing and the bulls restored to power. Then will be the time for investors to remember that, East and West alike, investment is a two-way street.

James Grant is the editor of Grant's Interest Rate Observer.

New York Times