Crashes, Like Bubbles, Call for a Level Head
What’s the inverse of a bubble? A panic.
That realization dawned on me last week as I watched otherwise rational people frantically selling stocks at any price. This was a panic, no doubt about it. But its uncanny resemblance to a bubble in all ways but the result may have struck me because the last bubble was so recent. Just this summer, I was examining the bubble psychology in oil and commodity prices. When I re-read what I had written, the comparison was striking. The following passage is word-for-word exactly the same as I wrote in my column of July 24, except that I have substituted the word “panic” for “bubble”, “margin buyers” for “short sellers” and “pessimism” for “optimism,” etc.:
“What defines a panic? …it starts with a development of far-reaching, perhaps unknowable, implications, like the collapse of mortgage backed securities. Opinion may be sharply divided between optimists and pessimists, but pessimists get the upper hand, driving prices lower. Margin buyers (optimists) get squeezed and are forced to cover, retreating to the sidelines. With pessimism unchecked and selling reinforced by ever falling prices, stock values become detached from any rational criteria. Trading
volume surges. Eventually, pessimism runs its course, prices turn up, and people step in to buy. Then prices surge.”
A difference, of course, is the predominant emotion, which is fear in a panic, greed in a bubble. Psychologists tell us fear is a more powerful emotion than greed. If last week is any indication, I’m sure it’s a less pleasant one.
As the Nasdaq was plunging last Wednesday through my latest buying target of 1750 with once unthinkable speed — it had crossed the previous target, 2025, just a week earlier — it occurred to me how wildly irrational the pace of this decline had become. What had actually changed in just a week? Not that much, when you think about it. The amount of toxic assets on the books of the world’s financial institutions was precisely what it had been a week before. Some European banks had wavered and had to be rescued. But none had failed. Governments were rushing to address an array of potential problems, which should have been, if anything, positive news for equities. But what were commentators comparing things to? The Great Depression
, which I once read was the worst economic contraction since the Black Death.
Suddenly everyone was speaking with certainty about dire consequences that simply can’t be foreseen. Just as in a bubble, price/earnings ratios were now irrelevant, because earnings were going to be so much lower than forecast. (In a bubble they’re going to be higher.) People were saying confidently that the Dow Jones Industrial Average was going to 6,000. (It was 20,000 in the bubble.) And of course, everyone was talking about how they’d just bailed out before the crash.
Except me. I haven’t sold a thing. Last Thursday, during a break in a college trustees meeting I was attending in the Midwest, I phoned in my buy order. The Nasdaq Composite Index was well below 1750. A beauty of my system is that it’s very easy to execute.
I didn’t need to waste much time thinking about what to buy. Everything was beaten down. There didn’t seem to be any point in stock-picking. As I’ve said before, at a time like this what you buy is less important than that you buy something. I divided my purchases evenly among four exchange-traded funds — SPDR Trust (SPY: 93.51*, -6.30, -6.31%), PowerShares QQQ Trust (QQQQ: 31.70*, -1.86, -5.54%), iShares MSCI Emerging Markets Index (EEM: 25.43*, -3.21, -11.20%) and iShares MSCI EAFE Index (EFA: 44.50*, -3.60, -7.48%) — pretty much spreading my money around the entire globe.
Stocks seemed to be making an attempt at steadying themselves that day. Then, in the last 20 minutes of trading, they went into another sickening plunge. I heard that people trying to buy or sell then couldn’t place orders. I was starting to feel a little kicked around. The next morning the Dow opened down more than 500. Would we be facing another 10% drop in just days? I stopped looking.
Friday marked the end of one of the worst weeks in Wall Street history. Then, after a beautiful autumn weekend in the Northeast, a new day dawned on Monday. Stocks soared above my buying target, putting my recent purchases in the black. The rampant pessimism, it seemed, had run its course at least for now, just like the optimism in a bubble. Have we hit bottom? There’s no way of knowing. All I can say is that historically stocks have outperformed every other investment category if held for the long term. Nothing in the recent past has convinced me otherwise.