- Two Things You Absolutely Must Know About Market Panics

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Two Things You Absolutely Must Know About Market Panics

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Two Things You Absolutely Must Know About Market Panics

Tuesday, 22 January 2008

by Justice Litle, Editorial Director, Taipan Publishing Group
Today I wanted to tell you about Tiddles the Human Bowling Ball -- but he’ll have to wait until tomorrow. Right now, we’ve got to address some more serious business. Namely, there are two things you simply must understand about market panics.
When Panic Strikes
I returned from the gym this morning to find a pink copy of The Financial Times in front of my hotel-room door. The front page headline was stark.

“Fears spark global plunge,” it said.

While American markets were closed on Monday in observance of Martin Luther King’s birthday, the rest of the world lost its collective head. It might have had something to do with The Wall Street Journal’s talk of “severe recession” right above the fold. Whatever the reason, things were ugly.

The numbers weren’t pretty. Indexes in Britain and Frankfurt saw their biggest single-day drops since 2001. Asian markets swooned. India’s Bombay Sensex dropped 5%; the Nikkei in Tokyo gave up nearly 6%; and Hong Kong’s Hang Seng dropped close to 9%.

Today isn’t looking much better. World indexes are either dropping hard or swinging wildly as I type. (As of this writing, U.S. markets haven’t opened yet.)

It’s not a fun subject. In fact, many would rather avoid it. Yet it doesn’t take a rocket scientist to see that panic is setting in.

Correlation Is Key

To understand what happens in market panics, it’s important to first grasp the concept of correlation.

Correlation is simply a measure of how assets move in relation to each other. When the stocks of two companies move in the same direction most of the time, they are said to be highly correlated. The same is true of indexes, currencies, commodities and so on.

The correlation coefficient is the standard way to measure correlation. It runs between plus one (1.0) and minus one (-1.0).

Two hypothetical markets with a correlation of one would move in the same direction 100% of the time. Two markets with a correlation of minus one -- said to be inversely correlated -- would move in perfectly opposite directions 100% of the time. All measurements fall somewhere between the two extremes of plus one and minus one. (A correlation of zero means there is no relationship; relative movements between the two markets are random.)
A Correlation of One

Why is this important to understand?

Because when panic sets in, the broad correlation of markets approaches one. The bigger the panic, the stronger this tendency becomes. Markets across the globe begin to move in lockstep.

This type of lockstep movement confounds the efficient market theorists. It just doesn’t make sense to them. It seems completely irrational for all assets everywhere to start moving sharply in the same direction at the same time.

And in a very important sense, it is highly irrational. There’s no valuation-based reason why assets across the globe should suddenly get hammered all at once. Who the heck went crazy with the discount stickers? It seems to fly in the face of logic. But on another level it makes total sense.

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One Portfolio, One Crowd

Global markets, you see, are connected in a way that efficient market theorists don’t think about. They are connected in a big way by leveraged speculators.

At first glance, there doesn’t seem to be a logical connection between, say, the British pound, natural gas and semiconductor companies. But a natural connection exists in the fact that many aggressive hedge funds trade all these things.

When a leveraged fund takes a hit in one area of the portfolio, it has to cut back in other areas to reduce risk. The portfolio thus becomes the contagion mechanism. If you have a number of players who are long the financials and long gold, for example, and suddenly the financials are getting killed, you’re likely to see gold sell off a bit, too.

Does this make sense? From a fundamental standpoint, not really. From a risk management standpoint, though, many of these leveraged players have no choice; they have to sell the good along with the bad to get their butts out of harm’s way.

On top of the portfolio contagion effect, panic can spread through the groupthink effect.

The reason that markets are mostly efficient, in a mostly-but-not-always-rational sort of way, is because investors’ opinions generally cancel each other out. When the opinions of the crowd are diverse and varied, the crowd acts like a weighing machine; outliers are averaged out, and reasonable valuations are the net result.

When the crowd develops a single-minded opinion, however, the natural market mechanism goes haywire. There is a critical mass of opinion -- a sort of groupthink tipping point -- beyond which markets can get pushed in extreme directions very quickly.

This happens on both the upside and the downside. In the dot-com boom and the housing bubble, we saw it on the upside; now we are seeing it on the downside. Too many people believing and doing the same thing at once overrides the system; it messes up how markets are hypothetically supposed to work.

The Two Things You Must Know

Now that we’ve got the basics (correlation and crowds) covered, here are the two things you must know about market panics:

1 Market panics are not a rational process; almost by definition, they are highly irrational.

2 Profiting from a panic is not about what stays up; it’s about what goes down too much.

Not a Rational Process

When panic sets in and correlations approach one, logic has left the building. Selling begets selling. The media latches onto surface level reasons and blindly uses them to explain everything.

If you remember that a lot of leveraged market players are selling because they have to -- not because they necessarily want to -- it helps to put things in perspective. When you think about what’s going on behind the scenes, both psychologically and logistically, it’s easier to see where the panic comes from.

Once you realize that market panics aren’t rational, the next step is seeking opportunity.

It doesn’t make sense for all assets to move in lockstep, because some assets are much higher quality than others. Still other assets -- like gold and silver, for example -- are actually likely to benefit from the emergency stimulus that is coming. But in the short run that doesn’t matter because -- wait for it -- the good and the bad are all getting irrationally dumped over the side.

It’s Not About What Stays Up; It’s About What Goes Down Too Much

This leads to the second key point: Profiting from panics is not about sticking with what stays up; it’s about buying what goes down too much.

A natural response to market ugliness is seeking out safe havens, trying to find those bolt holes where the pain can’t spread. That strategy can work under more normal conditions. However, when markets are looking sketchy, certain sectors and industries and commodities can still outperform.

But when we’re talking panic, all bets are off. In a panic, the correlations move towards one. Everything gets sold, whether the selling makes sense or not. (Again, that’s sort of the definition of “irrational” in the first place -- one of the reasons they call it “panic.”)

This is another area where the media goes badly astray. As prices fall, certain areas of the market are deemed to have “failed” because they are going down with everything else. Emerging markets and commodities, for example, are deemed to have “failed as a safe haven” because they aren’t escaping the panic.

But, in my view, that’s completely the wrong way to think about things. Market panics are simply a reality that must be dealt with, like occasional droughts in the Midwest or seasonal hurricanes in Florida.

The way to make money, then, is not to run away and hide, but to stick around and snap up the good stuff that is temporarily trading at fire-sale prices. This is how great fortunes are made. Value investors, for example, have made hundreds of billions of dollars buying beaten-down assets that other, more panicky investors threw away.

If you can look beyond current market conditions -- if you can understand the shape of things well enough to get a sense of what will happen three months, six months, 12 months down the road -- then you can translate that coolheaded perspective into an investing edge.

If you can recognize that certain assets look more and more attractive the further they fall -- because they never should have been tossed over the side in the first place -- that can be a powerful advantage.

Louis Pasteur observed that chance favors the prepared mind. He was right. And as it turns out, market panics favor the prepared mind, too. Times like these create real opportunity.

Seeing What’s Next

So remember those two key lessons. Here they are again:

1 Market panics are not a rational process; almost by definition, they are highly irrational.

2 Profiting from a panic is not about what stays up; it’s about what goes down too much.

In line with those lessons -- and seeing what’s next -- I encourage you to check out the emergency Taipan Video Summit scheduled to air on January 24 at 7 p.m. The video is completely free, and it somewhat discusses the market conditions we’re dealing with now.

You’ll hear from Sally Limantour, Adam Lass, Sara Nunally and myself in regard to “what’s next” for the global economy. We’ll cover topics like how the current crisis is likely to play out, the best places to position yourself, how to find outsized gains and hedge against risk and more.

More on that to come. And I look forward to telling you about Tiddles, too.

Warm Regards,

JL
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