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.