Nick Dewhirst examines the fundamentals and the psychology underlying current market behaviour
Panic! It is now an ideal time to add this item to my stockmarket lexicon, because January 2008 threatens to rank among the worst months for global stockmarkets in four decades. Panic happens when an orderly market retreat turns into a rout of indiscriminate selling, but why?
Panic is more likely if the economic cycle is weakening. Typically, strong growth leads to high capacity utilisation and rising inflation, so bond markets fall and interest rates rise, squeezing share valuations. Share prices can only stay high if profits continue growing, but eventually the combination of increasing capital investment and weakening demand causes profits to crumble. Then bear markets gather pace and end in panic.
However, panics can happen even if the economy is sound. In 1987 inflation had been creeping up towards 4%, but that was modest by the standards of that decade. The Fed raised interest rates once but historically it took three hikes for Wall Street to tumble. In 1998 Russia defaulted on its debts, but that did not impact the US economy. Neither panic was followed by recession.
This time there were deteriorating fundamentals, but they were already well known. Interest rates had been rising for four years, raw material costs had been soaring for three years, and the real estate bubble had peaked in the summer. The dangers for the global banking system were also clear, since the sub-prime crisis had come to light in May and the CDO market had dried up in July.
Nevertheless, for the remainder of 2007 investors differentiated correctly between declining domestic versus growing multinational sectors and between declining American and advancing Asian economies. Yet in January all sectors and all markets collapsed, irrespective of fundamentals.
In panics investors fail to distinguish between reasons and excuses. In October 1987 the Bundesbank was considered insensitive in raising its own rates by a percentage point over the preceding three months, but that was its job. In January 2008 the US economic numbers duly deteriorated, the monoline fig-leaf was blown away and various international banks announced huge write-offs, but banks also succeeded in raising replacement capital.
The simultaneous collapse in foreign markets is blamed on threats to the international banking system and discredited decoupling. However, these also are excuses, for the first is insignificant relative to the scale of operations outside the US, and there is no evidence for the latter. Of course a US recession will reduce economic growth elsewhere, but growth abroad is faster so a pro-rata slowdown is unlikely to be so severe that it causes recessions elsewhere.
Stockmarket crashes can be caused by exogenous shocks. Wars provide good examples, such as the Cuban missile crisis in 1963, the Arab-Israeli war in 1973 and the invasion of Kuwait in 1990. However, such crashes are justified by these shocks, and so differ from panics.
When investors ask for explanations, they get replies listing only negative stories. Yet security prices are determined by the balance between many different factors. Since people make decisions based on the weight of the evidence before them, this weighs their decisions negatively. The media make it worse, as once one journalist has uncovered a good story, a feeding frenzy develops, because their job is to whip up emotions, attract attention and sell more advertising.
The reasons for panic may be psychological. When pressurised for quick response on little information, our primitive instincts take over - run away and live to fight another day. Admitting mistakes is also painful, so some sell their winners, instead of their losers.
Meanwhile, professionals feel pressurised to placate restless investors, even though they know that panic makes for poor long-term investment, but that is irrelevant if their jobs don't survive the short term.
Investors may also panic because they have no choice. If some are operating on leverage, when markets fall, their bankers will demand more collateral. If they have no reserves, they become forced sellers. Some sell what they can, because they cannot sell what they should if those investments have become illiquid, like real estate and junk bonds now.
The necessary precondition for a panic is that the fashionable investment game had become too fashionable as markets eventually run out of new suckers to absorb the natural rate of selling. As participants increasingly sense this, their selling increases and prices begin falling at an accelerating rate. There is no telling in advance which excuse will prove decisive.
It was changing investment fashions caused the panics for conglomerates in 1968, growth stocks in 1973, gold in 1980, portfolio insurance in 1987, Japan in 1990, convergence in 1998, technology in 2000 and now carry-trades in 2008.
This time investors went long risk and short quality. Time and again, the lesson is the same - short-term gain, long-term pain.
- Nick Dewhirst is CEO of www.investors-routemap.co.uk.
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