The Anatomy of Fear

Remember irrational exuberance—the sense that stocks can only go up? The folly of the 1990s dotcom 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 only move in 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 dotcom 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 canvass 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.

Several psychological effects are at work. The failure of household names like Fannie Mae, Freddie Mac, Lehman Brothers and AIG saps confidence. "If you feel you can't trust the institutions, it's a trigger for anxiety," says psychologist Paul Slovic, cofounder of Decision Research. After the dotcom bubble burst, he found investors were still optimistic that investing in the stock market would enable them to meet their long-term goals. But in a survey that asked the same question on Sept. 29, the day the House of Representatives voted down the bailout package, respondents were deeply pessimistic about the short term.

Panic in a downturn, much like overconfidence during good times, is a form of social contagion, says Dr. Robert Leahy, professor of psychology at Weill Cornell Medical College. "People just begin listening to each other, and they feed off the bad news, just as they fed off the overly positive good news about housing prices going up four years ago," Leahy says. Next, confirmation bias, the process through which people blow fresh negative developments out of proportion, sets in.

When things start to head south, investors turn to the asset classes or sectors that have been doing well recently, or that tend to do well in bear markets. But this time, the shelters have been blown over by the storm—energy stocks, commodities, emerging market stocks, gold. For decades, money-market funds, which invest in high-quality short-term debt, have been the safest place to stow cash this side of the mattress. But the $3.6 trillion industry was rocked in September when a fund run by industry pioneer Reserve Management "broke the buck"—i.e., the value of its holdings fell below a dollar a share—the news started a run on money-market funds that required federal intervention. Fear then began hitting the market for highly rated municipal bonds, traditionally the safest, most boring place to stow money.