Even Panics Have Their Uses

The market took its prisoners on Monday and Thursday, and let them out of jail late Thursday afternoon. If you were one of the freed, watch out for those jailhouse doors on Monday. They're likely to clang shut again as it's the last day of the month, usually a bearish day.

But on the first day of February, be ready to bet the house.

Lots of stops were taken out when Standard & Poor's 500 futures broke through yearly lows at 1398 on Thursday. When the contract went from down 5 to down 25 in a matter of minutes, energy drained from the rest of the marketplace; Traders with stock for sale found few buyers; nobody wanted to get caught holding expensive stock in a downturn. Innocent stocks like BroadVision (BVSN Quote), Conexant (CNXT Quote) and Sun Microsystems (SUNW Quote) were suspended in air, with no traction for climbing.

Friday, the market opened down 1%. Bonds were down as much as a full point, and the major bullish underpinning of the market seemed to be eroding. Heart rates and blood pressure rose, hair stood on edge and skin crawled.

But the torture ended after a one-minute decline that took the active March futures contract down 0.5% more to 1392. Within 10 minutes, the market was back, and smiles and small talk were heard in trader's offices. By early afternoon, the bond was up a point and a quarter, sending the yield to the lowest since Dec. 13.

The market, like music, often speaks in the language of emotions. The S&P contract's gut-wrenching, 75-point decline this week spoke mostly with fear in its voice: Investors closed their eyes, drew their eyebrows together and hunched their shoulders.

Source: Harry Pincus

We were both trained as classical pianists, and often listen to music as we ply our trades of speculation and writing. The musical piece the market sounded most like to us this week was the first movement of Beethoven's Fifth Symphony, when the fateful short-short-short-long theme in a minor key collides with a major theme. The music slows to a heartbeat, and it seems like the end of the world.

The human psyche at moments of panic takes the path of least resistance, and goes straight to its most vivid, terrible memories. We were filled with a terrible awe as the declines of Monday and Thursday revived recollections of calamities like the crash of Oct. 19, 1987.

The problem with emotional reactions to market declines or other situations is that the behaviors elicited are often dysfunctional and ineffective. Smashing the dinner plates or selling out at market lows would hardly be what the doctor ordered. In hindsight, when we feel tightness of breath and butterflies in the stomach, the appropriate reaction is to buy. As the table illustrates, the market in each case was up one week later, with the average coming to a very nice 4%.

Notable Panics
Date	Decline that day (high to low)	% Move next day (high to low)	% Move next day (close to close)	% Change one week later
Oct. 19 1987	-25%	+26%	+5%	+9%
Oct. 27, 1997	-8%	+7%	+5%	+8%
Aug. 31, 1998	-7%	+8%	+4%	+8%
Jan. 24, 2000	-3%	+4%	+1%	--
Source: Bloomberg

Studies of other panic declines confirm that after the decline has hit 10%, it is generally a good time to buy. Our favorite visual representation of this is an illustration to "The Wall Street Rag" showing Scott Joplin laughing as the good times come back. The piece was written in commemoration of the panic of 1907, when the Dow Jones Industrial Average cratered 35%.

Vic's grandfather, also a speculator, studied with Scott Joplin, and was able to give the composer some vivid details about that particular decline. The piece is supposed to be played with syncopation, which to recalls the rapid down-and-up movements that characterize panic situations.

While fear can paralyze when action is appropriate, it has another dimension, a highly protective one. Hunched shoulders and frowning -- and sometimes, flight -- protect the vital organs. Survival is the key in market battles. Investors who didn't get out of the way during the 1987 debacle or the drawn-out crashes of the 1930s and 1970s met with market death.

Each of the bull market-interruptus panics in the table above ended quickly as a deus-ex-machina came to the rescue. The market rallied -- too late for some of us, true -- but rally it did.

Someday, the rescuer won't arrive with such dispatch.

That day probably won't be this Monday. The bonds are too good for that; they moved closer to 6% than 7% this week, removing one of the props of the negative market. And we've had three panics in five days. Nevertheless, ends of months and Mondays are usually bearish -- and they happen together only once a year. One of those was Aug. 31, 1998. So it's a good time to adopt the hardened glance of a seven-card-stud player and look at the probabilities.