Fear FactorHow anxiety and terror are making the financial catastrophe worse than it needs to be.
Posted Monday, Oct. 13, 2008, at 10:25 AM ET
The technology that transmits odors and fragrances digitally is still in the very early stages of development. But on Monday, Oct. 6, the whiff of fear emanating from the television was overwhelming. James Cramer—CNBC star, ex-hedge-fund manager, and mascot of the 1990s tech boom and the recent bull market—was throwing up his hands. "There's always a bull market somewhere" has long been one of his signature lines. But Cramer admitted to the Today show's Ann Curry that "somewhere" was now nowhere to be found. "Whatever money you may need for the next five years, please take it out of the stock market right now, this week," he pleaded. "I do not believe that you should risk those assets in the stock markets."
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StumbleUponIn the ensuing days, many investors—professional and amateur alike—took Cramer's advice. As a series of global convulsions shook markets from New York to Tokyo and all points in between, the stock markets plummeted, with the S&P ending the week down 18.2 percent and down 42.5 percent for the year. Amid a broad-based, expanding credit crunch and rising concern about fundamental economic weakness, no sector or region was immune. "The U.S. and advanced economies' financial systems are now headed toward a near-term systemic financial meltdown," says Nouriel Roubini, professor of economics at New York University and a longtime bear who has been vindicated in spades. There have been, and are, plenty of reasons for investors to freak out: the failure of banks; the demise of institutions like Lehman Bros.; the necessity for repeated, spastic government interventions. Nearly every economic indicator in the past few weeks, from auto sales to employment, has been negative.
The stock of General Motors sunk to its lowest level since 1950.
Banks are refusing to lend to one another. The traditional safe havens of investment, such as municipal bonds and money-market funds, have buckled. The trumpets of leadership are so uncertain, they sound like kazoos.
"The only thing we have to fear is fear itself," Franklin Delano Roosevelt proclaimed at his first inauguration in March 1933, amid the worst prolonged financial crisis in the nation's history. Yes, the banking system was a shambles and unemployment stood at 25 percent. But conditions would certainly improve over time, and a change in attitude would help. In recent weeks, as the comparison between today's financial crisis and the Great Depression has grown commonplace, it's become clear that fear itself is Wall Street's greatest fear. "Anxiety can feed anxiety," as President Bush put it. We see it manifested in many ways: in the plunging Dow, in spiking interest rates, in James Cramer's frenzied pleas, in the shellshocked silence of traders on the 5:01 p.m. New Haven-line train out of Grand Central Terminal.
Markets, we are told, continually process available information to spit out accurate gauges of reality in the form of prices. That's the theory. The reality: Markets are frequently inefficient, and dominated by humans, with all their frailties. "The view that people in finance are rational is wrong," says Alex Edmans, a Wharton School of Business economist who studies behavioral finance. "They're susceptible to emotion just like anyone." In recent weeks, the emotions they have been expressing include anxiety, panic, rage, and resignation. In the Depression, skittish investors would cause runs on the bank by lining up on the sidewalk to withdraw cash. In the past several weeks, we've witnessed a 24/7 digital run on financial institutions as investors, banks, corporations, borrowers, and lenders worry that their assets simply aren't safe. This panic has shown similar dynamics to previous ones. But because of the rapid shift in the structure of the global financial system, it's also completely different. As a result, the amount of selling and declines are far greater than would be warranted by the erosion in the fundamentals. Call it the fear factor.
Remember irrational exuberance—the sense that stocks can only go up? The folly of the 1990s dot-com bubble was repeated in this decade's housing and credit bubble. Since house prices had never fallen, the thinking went, they wouldn't fall in the future, which made it safe to buy—or lend—at any level. When we're all convinced a trend can move in only one direction, it tends to do so, which is how bubbles inflate. It's a natural human tendency to extrapolate forward from existing trends. But the dynamic also works in the opposite direction. We go swiftly from thinking nothing bad can happen to knowing that only bad things do.
Back in 2002, in the wake of the dot-com crash, the sentiment meter on the technology sector did a 180-degree shift. Apple's stock was trading for below the level of cash on its books, ascribing a value of zero to its brands and products compared with several billion at the height of the boom. The same shift has taken place in the past year in the stock market. In the spring of 2007, the Dow was aloft, interest rates were low, corporate profits were high, and the global economy was enjoying its sixth year of growth—everything that could go right was going right for investors. Oil was the only blot on this beautiful landscape. Now the canvas looks like a Jackson Pollock painting, chaotic and splattered with violent streaks. Oil, which fell to $80 per barrel in early October, is now the only bright spot. At a time when any bad outcome seems possible—Iceland nationalizing its banking sector, Fannie Mae and Freddie Mac failing—other bad outcomes become inevitable. GM going bankrupt? The entire banking system going down? Sure, why not? In the markets, where credibility is all that separates many companies from failure, that can become a self-fulfilling prophecy. If all the banks, student loans, and credit-card companies that had extended credit to you demanded payment now, would you be able to make good?
Although the drama is playing out in the global stock markets, the most severe trauma has been in the vast credit markets. Credit comes from the Latin credo, meaning belief. In recent months, lenders' collective dark-night-of-the-soul has evolved into full-fledged agnosticism. Investors don't trust banks, banks don't trust borrowers, mortgage companies don't trust home buyers. Around the world, lines of credit are being pulled or frozen. Interest rates, at root, are a reflection of the faith people have that they will get paid back. The greater the doubt, the higher the interest rate.
The most telling indicators of fear are the arcane data points followed by central bankers—the TED spread (the gap between the interest rate on Treasury bills and the rates American banks demand in return for lending money in the global markets) or LIBOR (the London Interbank Offered Rate), the rate at which banks lend to one another. A year ago, when credit markets first seized up, all these metrics spiked. But in recent months, they've soared to record levels. If the 2007 spikes looked like the Adirondacks, the readings today look like the Himalayas.
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