Think the unthinkable

“The terrible, cold, cruel part is Wall Street. Rivers of gold flow there from all over the earth, and death comes with it. There, as nowhere else, you feel a total absence of the spirit: herds of men who cannot count past three, herds more who cannot get past six, scorn for pure science and demoniacal respect for the present. And the terrible thing is that the crowd that fills the streets believes that the world will always be the same and that it is their duty to keep that huge machine running, day and night, forever. This is what comes of a Protestant morality that I, as a (thank God) typical Spaniard, found unnerving.” –Federico Garcia Lorca.

In every kind of disaster, writes Amanda Ripley in her excellent and moving study of disaster psychology (“The Unthinkable: who survives when disaster strikes – and why”, Random House Books 2008), we start in roughly the same place and go through three phases. The first phase is denial. According to a 2005 National Institute of Standards and Technology study drawn from interviews with nearly nine hundred survivors of the 2001 attacks on the World Trade Centre, the average survivor waited six minutes before heading downstairs. One survivor commented, “The building started to sway and everything started shaking. I knew there was something wrong. I ran to my desk and made a couple of phone calls. I dialled about five times trying to reach my [spouse]. I also called my sisters to find out more information.” Despite the physical evidence of smoke and the smell of jet fuel, about one thousand individuals took the time to shut down their computers. Once through the initial shock of the denial phase, we pass into deliberation (“We know something is terribly wrong, but we don’t know what to do about it. How do we decide ?”). Our processes of thought and perception are altered. Eventually we reach the third phase of the survival arc: the decisive moment; “We’ve accepted that we are in danger; we’ve deliberated our options. Now we take action.”

It might appear tasteless to compare the collapse of financial markets with real human disaster. It isn’t meant to be. Happily and hopefully, most of us will never experience the latter, so the threat of financial loss (delivered, or potential) will be more than enough to suffice.

That stock market price action has been so consistently dreadful with such little evidence of a sustainable floor despite flurries of ostensibly positive news (Santander / Alliance & Leicester; some form of formal pastoral care for Fannie Mae and Freddie Mac) could be interpreted as a sign that many investors remain trapped at the “denial” stage of this particular market disaster. Or perhaps many investors, institutional and individual alike, are now mulling their deliberative options. And some, presumably, have already reached the decisive phase, and already pulled the plug on much of their market exposure and initiated the dash for cash. This may or may not prove to be the prudent strategy; only time will tell. It certainly seems to show the merit in the advice that if you’re going to panic, panic early. We would merely hazard the following suggestion: the current market environment is flushing out those investors (supposedly “professional” and individual) who are congenitally unsuited to be making substantial portfolio allocations to the equity markets. The fiendish difficulty for those who decide to be out of the market entirely will be when to decide to get back in.

Classic Buffettology advises us to get greedy when others are fearful. This would ordinarily be sound advice, if somewhat difficult psychologically to execute. But if that blanket exhortation proves to be deficient or at least premature this time around, it will be because the nature of the problems facing financial markets, central banks and commercial banks is off the charts. It feels difficult because many of us have never been here before: only part-way through the historic bust of an extraordinary credit boom, only part-way through a property market correction that could yet last for months if not years, and only part-way through probably the gravest systemic crisis facing the banking system since the 1970s, if not indeed the 1930s. What accelerates and amplifies the downwave in stock markets is the state of our brave and newly inter-connected world where all investors are effectively neurons firing in a vast collective brain. And the global investment brain has suffered a stroke, an ischemic shock triggered by a sudden catastrophic lack of confidence mixed with heady deleveraging.

Citigroup’s Patrick Perret-Green takes up where John Kay of The Financial Times left off some weeks ago, in comparing the evolution of current market sentiment to Elisabeth Kübler-Ross’ “Five Stages of Grief”. The suggestion back in May that it might be time to buy because bankers had “moved on” from denial through to a state of general depression we now know to have been somewhat premature. Here is how Patrick now takes us through the grief arc:

  1. Denial – Credit markets have entered ludicrous levels.
  2. Anger – Why have I lost so much money ? It’s not fair !
  3. Bargaining – Cut rates. Give us liquidity. Give us capital.
  4. Depression – We’re all doomed.
  5. Acceptance – We can’t fight it. Let’s make the best of what we can and prepare.

He suggests, like John Kay did in May, that we are currently in the depression stage. “For doom-mongerers like me this is an event to be welcomed. When the masses, and particularly the popular media, wake up to things it often means that things are close to reaching overshoot territory. This doesn’t mean that things are set to rebound dramatically, far from it. But the pace of decline may ease significantly.. What’s happening to Fannie and Freddie is, perversely, a healthy development. The GSE [Government Sponsored Enterprise] debate has gone on for many years and for far too long there has been a woeful lack of political willpower to address their hybrid status and the explosion of their balance sheets. Only now.. are actions of a far-reaching nature being taken.. More broadly the GSE issue has rammed home the force of our long-term argument that the credit crunch will only be resolved through widespread public sector involvement. As with Scandinavia and Japan in the nineties and noughties, and for that matter the US in the eighties, the problem is too big for the private sector to fix. That means that, thankfully, we are now tentatively beginning to enter Stage 5 – Acceptance.”

Patrick believes, as I do, that the logical outcome from this is higher Treasury yields, notwithstanding the interest rate cuts that the monetary authorities would like to throw at the banking system but from which they are prevented by frustratingly high inflation. All things being equal, then, perhaps the real danger to come is not just lower equity markets (future market direction ? How long is a piece of string ?) but lower government bond markets too. Yes, the economic slowdown and the long-awaited oil price correction would conceivably suppress inflation. But somebody is going to have to pay for all these financial sector bailouts, and while it is gratifying to see Spanish banks stepping up to the plate, it is taxpayers who are ultimately going to get profoundly stuffed (plus ça change..) before this crisis is through. Given the complex and highly opaque outcomes that overhang so many asset classes, has there ever been a better time to be highly diversified by investment instrument, with a reduced dependency on both equity and bond markets, and with an overriding focus on absolute return ? Or to return to the theme with which we began this week: regardless of whether financial market conditions might deteriorate markedly further from admittedly distressed levels, equating, in other words, to potential “money disaster”, do you have a plan ?

Originally published at The Price of Everything and reproduced here with the author’s permission.