Wednesday, October 08, 2008

The Financial Panic of 2008


It looks like the chart of a fallen bank, but it's actually the daily price chart of the S&P 500 Index futures as of this morning's pre-opening trade. Market history is replete with instances of stock market panics. Since the Great Depression era, we've had panicky periods of selling, but no labeled "Financial Panics". Panic, psychologically, connotes a loss of orientation and an overwhelming sense of anxiety, just as Depression connotes hopelessness and an overwhelming sense of loss.

It is interesting that we use these psychological terms to label periods in financial history, but it is fitting. When institutional investors lose confidence in the financial system, what else can they do but hit the panic button, sell their assets, and do their best to preserve capital? When individual investors see their retirement assets--from their homes to their bonds to their stocks--down more than 20% and in seeming free-fall, it's understandable that psychological depressions become financial ones.

Several things seem clear amidst panic selling and depressing prospects for the economic future:

1) Piecemeal measures, institution by institution and country by country, are not enough to instill confidence in markets. Markets are global, and the response to credit crises needs to be coordinated and global as well;

2) Normal historical indicators of market bottoms are broken. We cannot count on market rallies simply because we are oversold, even though those oversold levels may have represented past opportunity. As long as money flows are negative and traders are hitting bids in size, weak markets will get weaker;

3) People don't recover from panic until they feel security; they don't recover from depression until they perceive hope. It will take more than a few government bailout announcements to instill renewed trust in markets and the financial system.

Essential to psychological stress is a loss of perceived control: we no longer feel in control of the outcomes that matter to us. By focusing on what we *can* control--how we trade, how we invest, how we plan for the future--we are best able to cope with whirlwind events that we cannot control.
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4 comments:

The Financial Philosopher said...

Thanks for useful observation, Dr. Brett! It's interesting to observe behavior that is irrational, yet predictable, in "real time..."

How many times have investors, traders and behavioral finance observers noted the classic patterns of market sentiment and emotion?

Now that we have reached the most challenging portion of the market sentiment cycle, this "knowledge" is not helping many people.

We knew complacency would be followed by greed, hubris and fear. We now have panic, as you have observed, and capitulation is either here or just around the corner. Next, once the financial crisis stabilizes, despondency will replace panic as we observe (or experience) increased unemployment.

Then hope will return and we can begin the cycle again...

This crisis is certainly educational and would be quite entertaining if it weren't so scary!

Similar to a Halloween "haunted house," we expect to be "scared" but we do not know how or when it will occur, even as we step into it...

"Men are disturbed not by things, but by the view which they take of them." ~ Epictetus

"When the mind is in a state of uncertainty the smallest impulse directs it to either side." ~ Terence

"Perception is strong and sight weak. In strategy it is important to see distant things as if they were close and to take a distanced view of close things." ~ Miyamoto Musashi

Marc said...

Brett,

You're not saying "this time it's different" are you?

Cheers,
Marc

Chris said...

Why are so very few bloggers/analysts/central bankers attacking the underlying problem in this crisis: OTC Derivatives. This is more than panic. We have never had a financial crisis where there have been over $1 Quadrillion in notional derivatives outstanding, with at least half of that value in OTC Derivatives (ie unregulated derivatives). The effect of this derivative structure is to amplify the leverage of the economy. This is fine and dandy when credit is expanding. But as we can see all hell breaks lose when a period of deleveraging occurs. We desperately need more widespread analysis of this issue because OTC derivatives are the catalyst that is causing this crisis to worsen in the face of unprecedented global intervention.

gamingthemarket said...

Using Crisis To Monopolize Fed Control

"The New York Fed pushed forward on July 31, 2008 with the next leg of a master plan. They are working to completely reform global OTC derivatives markets into a single central counterparty (CCP). This will put market control in the hands of 17 banks. Two prime brokers in the US market are Morgan Stanley and Goldman Sachs."

http://www.gamingthemarket.com/2008/07/using-crisis-to-monopolize-fed-otc_23.html