History of Fear: Only Reaction Matters

With apologies to Pink Floyd...

Mother, do you think they'll drop the bomb?
Mother, do you think they'll light the sun?
Mother, do you think my stocks will fall?
Mother, should I build the Wall?
Mother, I will trust my president.
Mother, I will trust my government.
Mother, will they put me in the firing line?
Ooooo, is it just a waste of time?

Hush now traders, don't you cry.
The market won't make all your nightmares come true.
The market won't put all its fears into you.
We'll all try to keep you under our wing.
You probably did cry; it's now time to sing.
But money can't keep you tender and warm.
Ooo baby ooo baby ooo baby
Never, ever build the Wall

---

Armageddon can't be delegated, and it sure as hell won't be won by the side gripped in fear. I frequently insert lessons from military history into my discussions of trading and markets -- not out of any morbid fascination with human sorrow, but rather in recognition that people and their institutions must be studied at the margins to understand who and what they really are. Nothing else matters. No one today remembers Churchill's wandering in the political wilderness in the late 1920s and early 1930s, and there's a reason why Americans so often turn to war heroes as political leaders.

Defeat and impending defeat often produce wildly divergent psychological outcomes. Let's take two examples of rescue from calamity, one successful and the other not. The British evacuation at Dunkirk in May 1940 was a stunning national triumph on top of a catastrophic defeat; even though its army was kicked off the Continent, the salvation of so many troops instilled a sense of confidence into the teetering nation. On the other hand, fear and acceptance of an inevitable defeat create a self-fulfilling prophecy. By all accounts, Gen. Friedrich von Paulus of the German Sixth Army trapped at Stalingrad in the winter of 1942-43 first relied on unrealistic hopes of rescue, and then in a fit of depression came to accept defeat as inevitable. Soon it was so.

Investors' behavior last week exhibits both characteristics. Some assessed the best course of action as getting off the beach to fight another day. Others clung to hopes and history and said this, too, shall pass. Both actions are defensible in prospect; only one will be correct in retrospect.

Nostradamus Doesn't Live Here Anymore

Forecasting is difficult. The whole art and science of market analysis depend on the repetition of relationships that have held in the past and have some justification in financial and economic theory. But the stunning rise from October 1998 to March 2000 defied logic. Who doesn't remember analysts scrambling to justify valuations and constructing "new metrics," whatever they were? The swoon in 2001, even before Sept. 11, confounded many analysts who expected a series of interest-rate cuts to stabilize both the economy and the market.

Abnormal times produce abnormal outcomes. The way people and systems perform under extreme conditions is the only thing that matters. Let's look at just how abnormal things are right now with a combination of measures demonstrated twice before, once just after the April 2000 selloff and again in October 2000 after the attack on the USS Cole. First, we can measure the surge in anxiety by comparing current volatility -- the market's price of uncertainty -- with the previous month's average volatility. Second, we can compare the current value of the market with its last new high; this is called retracement of gain, often a useful measure of how much pain we feel.

New World Order: SPX Volatility as a Function of Gain Retracement May 1996-September 2001

Source: Bloomberg

Previous capitulation bottoms are highlighted on the chart, and a trend curve is added to demonstrate how excess volatility accelerates as losses mount. The week of Sept. 17 is easy to identify. All five days are in the upper right-hand corner of the chart. In terms of both excess volatility and retracement of gain, we exceeded all experiences of the past five years and probably those of any time other than the Great Depression.

Who Shall Rescue Us?

As a longtime critic of central banks, let me give credit where it is due. The Federal Reserve recognized its duty to forestall a liquidity gridlock in the banking system, and its actions of the past two weeks are to be commended. But, beyond forestalling an immediate credit crunch, can monetary policy produce the desired outcome in equity prices? The recent history is not at all encouraging. Let's take, as we have so many times before, the ratio of the forward rate from one to 10 years -- the rate at which we can lock in borrowing for nine years starting a year from now -- to the 10-year rate itself.

Shape of the Yield Curve and Stock Prices

Source: Bloomberg

The abrupt steepening of the yield curve in 2001 produced by the Fed's easing policies is unprecedented. The last easing cycle ended in 1992, but stocks didn't break out to the upside until the end of 1994. The Fed is trying to ride to the rescue, but those infamous long and variable lags associated with monetary policy are going to force us to wait.

If the Dunkirk analogy to last week's market is correct, things will get worse before they get better, even if a rescue of historic proportions occurs. If the Stalingrad analogy is correct -- and let's hope it isn't -- we will hunker down to no avail. Bluntly, waiting out this siege from behind your own Wall makes sense only if you can afford to do so.