In like a lion....

March certainly started off with a bang, as worldwide equity indexes plunged over –4%. We now appear to be watching “Panic, The Sequel.” But unlike the panic selling that occurred in October and November, which was justified to some degree because of fear that the entire global financial system could collapse, no such risk exists today. Governments worldwide have gone to extraordinary lengths to rescue the banking system and restart lending, as well as stimulate the economy. There’s no longer any question that we’ll come out of this crisis; the only issue remains exactly when, and how much more pain we might have to bear in the interim.

Concerns about bank nationalization should not be an issue, either, as the stocks of banks most at risk of being nationalized (here or abroad) already trade at prices reflecting this. And if nationalization of one or more US banks were to occur, the experience of Sweden in the 1990’s with their banking crisis should provide solace that such an outcome does not portend disaster.

Yes, AIG reported a huge $60 billion loss, but this has been expected for several days. And HSBC (one of the world’s largest banks) said it plans to raise $17.7 billion in equity—but this will be private money, not from the government. It’s actually impressive that a bank feels it can raise private funds without a government backstop. Moreover, most of the economic news today was better than expected. The ISM manufacturing index came in higher than anticipated. Personal income and spending both rose in January, while most people were expecting it to fall.

Oil prices dropped 10% today after rising strongly last week. But paradoxically, copper prices (as I’ve mentioned before, one of the early indicators of economic recovery) fell less than 1%, and copper remains well above its December lows. Even stranger, gold prices fell slightly as well, which you wouldn’t expect if investors were preparing for Armageddon.

So we’re seeing panic selling when the economic environment does not justify panic, and when trading in other markets suggests the opposite. What’s going on here? Why the panic selling? And when might it end?

Interestingly, the last 2 bear markets (1990–91 and 2000–2003) also had a secondary panic phase. Not only that, but both primary panics occurred in October, with the secondary panics ending 3 to 5 months later. We’re now just under 5 months from the October panic and 3 1/2 months from the November one. Seems we’re right on schedule.

Why has this pattern repeated itself? I suspect it has to do with the rise of hedge funds. These highly-leveraged investors sell heavily during the primary panic to rapidly reduce their leverage and meet anticipated redemptions. Other investors, such as mutual fund owners, follow the hedge funds’ lead as they see stock prices tumble. The primary panic burns itself out when the hedge funds stop selling.

The secondary panic starts with a more orderly decline in prices, driven largely by individual investors (including owners of mutual funds) and less nimble institutions such as pension funds, with hedge funds largely sitting it out. This is because they’ve already raised a large amount of cash and no longer have an urgent need to sell. Finally, having endured a couple of months of steadily falling prices, an ever greater number of investors throw in the towel and head for the exits. While all kinds of investors participate in this final market “blow off,” the driving force is the individual investor, who is typically the last one out, both at market bottoms and at market tops.

Trading data from the past several months support this scenario. Individuals have been big sellers since mid-January, while hedge funds have backed away from selling. This is also in keeping with the adage that the individual investor has the worst possible timing, selling at the bottom and buying at the top. Why should this time be any different?

Selling during a panic such as the current one can be very dangerous, because reversals tend to be rapid and powerful, as well as unexpected. And panics tend to be short: the rapid declines of last October and November each lasted only 5 trading days. During these brief stretches, stocks fell 22% in October and 18% in November. The current panic is now 3 days old, and the S&P 500 has dropped about 10% during that time. Obviously, I can’t say exactly how many days this one will last nor how much stocks will fall, but 5 days and 15% is as good a guess as any. In any case, it’s likely to be over very quickly.

Recoveries after panics can be impressive. In October, the S&P 500 soared 23% in only 2 1/2 trading days. In November, the surge was 21% in 5 trading days. In other words, the losses can be recovered almost as quickly as they occurred. One has to be extremely nimble to take advantage of such rapid price movements as they occur.

Because of the rapidity and unpredictability of panics, I tend to sit them out, neither buying nor selling. Sometimes, I’ll make purchases on day 4 or 5, but one has to be very brave to do so. It’s usually safer, and certainly less nerve wracking, to do so after the first definitive up day.

Bear markets are always unpleasant. This one has been the most severe since 1932, so it’s certainly normal to feel worried (or even a little panicked along with other investors) during these rapid down moves. But they all do end and give way to new bull markets. Even the one in 1932 did so, and provided investors with some of the most impressive returns in US stock market history. Investors who stayed the course from the high in 1929 to the recovery in 1937 made back 99.5% of their money after inflation. This is pretty impressive after the mother of all bear markets. 2007–2009 has been bad, but not nearly as bad as 1929–1932. And the recovery, when it finally comes, should be very profitable.

I know the temptation to sell now may be very strong. Obviously, lots of people are giving in to that temptation, which is exactly what is driving prices lower. But it will be a long-term mistake to do so, and perhaps a short-term mistake as well. And I’m not recommending anything different from what I’m doing with my own money, as my personal accounts remain heavily in equities. I feel the pain of loss just as much as you, but I also know that acting on that pain can make for very bad decisions. Sometimes doing nothing is the best course of action. Now may be one of those times.