Pressing All the Buttons for a Panic Attack

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August 6, 2011
Pressing All the Buttons for a Panic AttackBy JULIE CRESWELL
BRADLEY ALFORD, a money manager in Atlanta, just hit the panic button.

No, really. Mr. Alford just hit the key on his computer that initiates the Wall Street equivalent of the nuclear option: Sell everything.

He was acting on orders from two wealthy clients who became so alarmed by the troubled outlook that they simply wanted out. Over the last 10 days or so, they asked him to sell all of their stocks and invest in a mutual fund he oversees that is somewhat insulated against a potential market collapse.

“I have never, ever done it before,” says Mr. Alford, who is the chairman of Alpha Capital Management and has been managing money for 22 years. “This was unprecedented.”

The pros on Wall Street are forever telling us to keep socking our money away in that 401(k) plan and to keep believing, whatever the market’s daily ups or downs. But after a week like the one we just had, the worst since the dark days of 2008, even the smart-money crowd seems to have second thoughts about the old steady-as-she-goes approach.

As the Dow Jones industrial average plunged 513 points last Thursday, then gyrated wildly on Friday, all of Wall Street seemed to be asking the same question: What the heck is going on? Evidence that the American economy is bad and growing worse has been piling up for a while now. And it’s not as if we didn’t know Europe had a debt problem. Why, then, all these crazy swings?

One possible answer comes from, all of places, the fields of psychology and neuroscience. In recent years, an area of study called neurofinance has tried to use brain science to explain how our primal circuits can, and often do, override our reason when it comes to investing.

It’s a heretical thought on Wall Street, where most people insist that logic prevails. The economic theory of rational expectations has enshrined the principle that people make judicious economic choices and learn from their mistakes. As a result, our collective expectations about the financial future — from the price of T-bills next week to the earnings of Google next quarter — are, on average, accurate.

Or so the theory goes. In practice, we do stupid things all the time. Some of us gamble away money, doubling down when logic tells us to quit. Others let their winnings ride when any rational person would cash out.

But many experts say the 2008 financial collapse recalibrated investor psychology. After living through the collapse of Lehman Brothers and the panic that followed, some investors are apt to sell first and ask questions later. Wall Street’s notion of worst-case scenarios has darkened considerably.

The result: the markets go wild. After a little good news on jobs on Friday — new figures showed the jobless rate slipped a notch in July — the Dow bolted higher. But by noon it had plunged more than 400 points from its morning high. It closed at 11,444.61, down 5.75 percent for the week and 1.15 percent for the year. Like most major markets, the American stock market has now officially entered a “correction,” one of those mini-bear markets that sometimes prove fleeting and, sometimes, are a harbinger of worse to come.

FINANCIAL markets rarely move in straight lines, and whatever the pundits say, it’s not always easy to pinpoint what made them move this way or that on a given day. But in New York, London, Tokyo and beyond, a broad shift appears to be occurring. All those graphs and charts are, basically, a representation of our collective financial neurocircuitry getting a bit panicky.

Some large investors, including wealthy individuals who lost big during the 2008 collapse, have more or less been stashing money under the mattress. They have been selling investments aggressively and seeking safety in cash. Over the last three weeks or so, hedge fund managers have been betting that stocks will fall further.

Dick Del Bello, senior partner of Conifer Securities, a company that provides administrative support to hedge funds, says funds have started to place more wagers against the markets, if only to protect themselves. But as a whole, he says, they are still betting that stocks will go up, rather than down.

“Hedge funds decided to add to their short positions and play more defensively,” he says.

And yet it seems clear that Wall Street is finally realizing what many ordinary Americans have been feeling for a while: these hard times are turning harder. Sure, major American corporations are making fistfuls of money. But smaller businesses aren’t. The American consumer confronts a toxic mix of weak home prices and high unemployment. Confidence is fragile.

Granted, people have been trying to explain the financial markets for more than a century. In 1900, the French mathematician Louis Bachelier argued that markets were essentially random. In other words, no one can forecast the markets accurately.

John Maynard Keynes, in his famous 1936 work, “The General Theory of Employment, Interest and Money,” likened the stock market to a beauty contest that ran in the newspapers of his day. Readers were asked to pick which would be voted the prettiest face. The key to selecting the winner, Keynes argued, wasn’t choosing the face you think is the most beautiful, but rather anticipating the face that others will pick.

Such theories aside, the uncertainties in the financial world now seem to have overloaded our collective financial brains, at least judging by the markets.

Denise Shull, the founder of Trader Psyches, which consults funds and investors on neuroscience strategies, says many investors are using the 2008 panic as their new reference point. After so many people lost so much money, many investors no longer hesitate to sell at the first sign of trouble, he says.

“How your brain deals with uncertainty — when it recognizes it is in an uncertain situation — is that it tries to pull it from a bigger context,” Ms. Shull says. “The context of 2008 and not wanting to see it happen again would absolutely influence these people to hit the sell button. Then it becomes self-fulfilling for the market.”

IT has actually been relatively easy to make money on Wall Street over the last year or so. Buoyed by hopes that the Federal Reserve would be able to reignite growth through quantitative easing, its controversial bond-buying program, the American stock market shot up last August and kept on rising fairly steadily through this May.

That run gave investors, the pros and individuals alike, a false sense of security, says Roy Niederhoffer, who runs a money management firm called R.G. Niederhoffer Capital Management.

Mr. Niederhoffer has a degree in computational neuroscience from Harvard and is a big believer in the idea that neuroscience can help people invest. He says he was surprised at how complacent investors have been, given Europe’s problems, the slack American economy and, until a deal last week, the debt-ceiling showdown in Washington.

One measure of that complacency is the Chicago Board Options Exchange’s VIX index, which uses the price of stock options to measure investors’ expectations about future volatility. After spiking following the earthquake in Japan this year, the VIX drifted lower through June and remained relatively subdued until early July. It has since shot up, although it remains far below the record levels hit during the financial crisis.

Richard Sylla, a finance professor at the Stern School of Business at New York University who has written about market sell-offs, said the plunge last week had all the hallmarks of a classic panic attack. The debt-ceiling debate, concern over the American economy, Europe — the bad news just kept coming, and investors finally snapped.

“When you pile all of those things together, investors become queasy,” he says.

Mr. Niederhoffer agrees. “I think, without question, there’s been a tremendous shift in psychology, but it took a while,” he says. Even when the market began to wobble last month, many investors refused to throw in the towel.

Mr. Niederhoffer has actually had a tough time because investors have been so complacent. He tends to zig when other investors zag, known as a contrarian strategy. Last week, two of his hedge funds were up 8.6 percent and 13.5 percent.

Now he smells opportunity. “We see what’s happening as a return of the psychology of the markets in 2007 and 2008,” he said. “This feels like it’s got legs.”

If he’s right, investors had better fasten their seat belts.