The Anatomy of Fear, and Its Effect on the Economy

The technology that transmits odors and fragrances digitally is still in the very early stages of development. But on Monday, Oct. 6, the whiff of fear emanating from the television was overwhelming. James Cramer, CNBC star, ex-hedge-fund manager, mascot of the 1990s tech boom and the recent bull market, was throwing up his hands. "There's always a bull market somewhere" has long been one of his signature lines. But Cramer admitted to the "Today" show's Ann Curry that "somewhere" was now nowhere to be found. "Whatever money you may need for the next five years, please take it out of the stock market right now, this week," he pleaded. "I do not believe that you should risk those assets in the stock markets." (Article continued below...)

In the ensuing days, many investors—professional and amateur alike—took Cramer's advice. As a series of global convulsions shook markets from New York to Tokyo, and all points in between, the

stock markets plummeted, with the S&P ending the week down 18.2 percent, and down 42.5 percent for the year. Amid a broad-based, expanding credit crunch, and rising concern about fundamental economic weakness, no sector or region was immune. "The U.S. and advanced economies' financial systems are now headed toward a near-term systemic financial meltdown," says Nouriel Roubini, professor of economics at New York University and a longtime bear who has been vindicated in spades. There have been, and are, plenty of reasons for investors to freak out: the failure of banks; the demise of institutions like Lehman Brothers; the necessity for repeated, spastic (and, so far, ineffective) government interventions. Nearly every economic indicator in the past few weeks, from auto sales to employment, has been negative.

The stock of General Motors sunk to its lowest level since 1950.

Banks are refusing to lend to one another. The traditional safe havens of investment, such as municipal bonds and money-market funds, have buckled. The trumpets of leadership are so uncertain, they sound like kazoos.

"The only thing we have to fear is fear itself," Franklin Delano Roosevelt proclaimed at his first Inauguration in March 1933, amid the worst prolonged financial crisis in the nation's history. Yes, the banking system was a shambles and unemployment stood at 25 percent. But conditions would certainly improve over time, and a change in attitude would help. In recent weeks, as the comparison between today's financial crisis and the Great Depression has grown commonplace, it's become clear that fear itself is Wall Street's greatest fear. "Anxiety can feed anxiety," as President Bush put it. We see it manifested in many ways: in the plunging Dow, in spiking interest rates, in James Cramer's frenzied pleas, in the shell-shocked silence of traders on the 5:01 p.m. New Haven-line train out of Grand Central Terminal.

Markets, we are told, continually process available information to spit out accurate gauges of reality in the form of prices. That's the theory. The reality: markets are frequently inefficient, and dominated by humans, with all their frailties. "The view that people in finance are rational is wrong," says Alex Edmans, a Wharton School of Business economist who studies behavioral finance. "They're susceptible to emotion just like anyone." In recent weeks, the emotions they have been expressing include anxiety, panic, rage and resignation. In the Depression, skittish investors would cause runs on the bank by lining up on the sidewalk to withdraw cash. In the past several weeks, we've witnessed a 24/7, digital run on financial institutions as investors, banks, corporations, borrowers and lenders worry that their assets simply aren't safe. This panic has shown similar dynamics to previous ones. But due to the rapid shift in the structure of the global financial system, it's also completely different. As a result, the amount of selling and declines are far greater than would be warranted by the erosion in the fundamentals. Call it the fear factor.

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.

It's not all in our heads, though. For in the last few months, there have been plenty of good reasons to worry about the health of Main Street and Wall Street. Jobs fell by 159,000 in September, the ninth straight month of losses. Auto sales fell by 26 percent. Retailers from J.C. Penney to Nordstrom reported disappointing September sales, and began dialing back expectations for the vital Christmas season. The sudden freezing of credit, on top of the poor fundamentals, has killed confidence. In the week from Sept. 18 to 25, 79 percent of consumers interviewed for the University of Michigan consumer-confidence survey expected a bad economic year, up from 57 percent earlier in the month.

During good times, economists note the presence of a "wealth effect." Higher home or stock values make people feel more financially secure. Now, as home prices continue to fall—down 9.5 percent in September 2008 from the year before—and 401(k)s wither, we're seeing what might be dubbed a "poverty effect." "The heightened financial turmoil that we have experienced of late may well lengthen the period of weak economic performance and further increase the risks to growth," Federal Reserve chairman Benjamin Bernanke somberly told the National Association for Business Economics in Washington on Oct. 7, a day when the Dow fell 508 points.

Time was, a few well-placed words from the Federal Reserve chairman could bring a market panic to a halt. In the 1990s, global markets had an ironclad faith in the ability of Fed chief Alan Greenspan, and his cohorts in the Clinton administration, to work their way through economic crises. Bernanke gets no such benefit of the doubt. He and his fellow economic firemen—Treasury Secretary Henry Paulson, Bush and congressional leaders—have taken bold, decisive action, as they continually remind us. It just hasn't been working for the past year. The bailouts, starting with Bear Stearns in March, and growing in size and frequency (nationalizing Fannie Mae and Freddie Mac; throwing a lifeline to AIG; guaranteeing money-market funds; the $700 billion bailout), seem to only have begat more panic. Why? Since the first measures didn't work, investors fear that the most recent one won't either. We keep taking injections to fend off the fever. But each time, a larger dosage lasts for a shorter time. Will the latest booster shot—the plan announced Friday, Oct. 10, for the government to take direct stakes in banks—prove to be an effective inoculation?

The protestations from on high are that, underneath the disaster, the fundamentals are still strong, that we'll work through this because we're Americans. "Fellow citizens," Bush fumfered Friday, "we can solve this crisis—and we will." Unfortunately, his reassurances seem about as calming as the scene from "Airplane" in which the flight attendant urges everyone to remain calm while all hell breaks loose. We have no Churchills today, and our financial leaders all seem to have fled to a bunker. On CNBC, Tyler Mathisen practically begged a name-brand CEO—anyone—to come on the air and speak to the American people.

For now, we have to seek solace in small positive signs: decent earnings from IBM, a week going by without a major financial institution failing. The most crucial indicator of an end to the rising fear may be, counterintuitively, more of it. Students of bubbles note that investor sentiment is always most bullish when a market is about to hit a top (when Business Week ran a cover story in 1979 heralding the "Death of Equities," it signaled the start of a long-running stock-market boom), and most bearish just when it's about to bottom. But when there's nobody left to lose confidence, when the ultimate stock guy throws in the towel and urges people not to buy stocks again until 2013, that sure smells like capitulation.