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City & Business: No stopping shares

LAST week we were subjected to the supreme example of how derivative trading is beginning to dominate activity in equity markets. The episode centred on UBS, which spent up to pounds 1bn in a single day buying constituents of the mid 250 index so as to cover a warrant it was selling to clients on the index. As a consequence the mid 250 went through the roof.

Something similar happened to the FT-SE 100 share index in the week before Christmas. Billions of pounds of stock was bought by a major Swiss bank so as to provide hedging instruments for a number of substantial pension funds. The market rocketed as a result.

Even ignoring these huge over- the-counter transactions, it is not uncommon these days for futures activity in equities to exceed the volume that's taking place in the stock market - to use the cliche, the tail is beginning to wag the dog.

Investors use derivatives because they are cheap, efficient, quick, provide a good hedge and, in some cases, avoid stamp duty. Many derivative transactions are also outside the Stock Exchange's control.

To some, however, it looks as if ballooning derivative trading has begun severely to distort movements in the underlying markets. Take that warrant transaction. Investors were buying the warrants as a bet on the mid 250 going up; when UBS moved into the market to cover the position, it became like a self-fulfilling prophecy, a case of the blind leading the blind.

Rubbish, say exponents, and even if this is true, does it really matter? If there were no warrants and other futures instruments available, investors would simply go out and buy the underlying stock instead. The effect would be largely the same: share prices would rise, though perhaps over a longer period of time. The equity market might seem to be at the beck and call of derivative traders, but in truth derivatives merely reflect what people think will happen anyway. Derivatives certainly cause short-term fluctuations but there's no long-term distortion.

Have the traders got it right? For the time being, investors seem intent only on driving the market higher. Good economic news is taken as evidence of recovery and shares move on to higher ground. Poor economic news is seen as evidence that the recovery is faltering and therefore another opportunity to cut interest rates; shares again move on to higher ground. It's become a case of heads I win, tails I win.

There's got to be something wrong with this no-lose logic. One day it's going to come unstuck, but for the time being it's hard to find an equity strategist who agrees. London still looks cheap against continental markets; shares will go higher before they go lower again.