Reason tells us that 1+1=2. It tells us that if you leave milk out for too long, it will spoil. It tells us that cars need gasoline in order to run.
But, what if the milk spoils even though we’ve kept it in the fridge all this time? What if our car doesn’t start even though we have a full tank of gas? We might tell ourselves that maybe it’s one bad sample, or an issue with our engine. And so we get another carton of milk at the store, and we bring our car in to the shop. But this second glass of milk is spoiled too, and the mechanic says that while our car is a bit nicked up, he has no clue as to why it isn’t starting. And so we think to ourselves, what the hell is going on?
Welcome to the financial crisis of 2008.
Reason would tell us that Thursday ought to have been a good day for the markets. The Fed announced that it would cut its short-term rates by 0.5% to 1.5% (a four-year low). Because lower rates diminish the cost of borrowing (thus encouraging liquidity), usually such a move would cause the markets to jump. The last rate cut in April was only 0.25%, and the Dow jumped 100 points the next day. The previous rate cut of 0.75% on March 18 caused the Dow to jump 420 points. So, with Thursday’s cut, we could have reasonably expected the Dow to rise anywhere from 100-400 points… or, at the very least, be slightly up.
Similarly, reason would tell us that if a big, blue-chip company hits its earnings targets, the market should respond favorably. After market close on Wednesday, IBM announced that it beat third-quarter expectations and would maintain its year-end target. The stock naturally went up 6% in after hours trading. With this good news, we could reasonably expect that the market would at least calm down on Thursday, and rampant fears about tech stocks would be lessened.
Finally, reason would tell us that if the first two instances occurred (big rate cut, strong earnings from a Dow Jones stock), AND no negative news was reported–then we could expect the market to move up, or at least stay somewhat steady.
But instead, on Thursday, we saw the Dow Jones Industrial Average fall 679 points, closing about 7% lower than it opened. We saw IBM rise and then drop, finishing right about where it was before it announced earnings, at $90. Staying flat was good comparatively, however, as the tech-heavy Nasdaq index dropped more than 5%. In the month of October, the broad S&P 500 index has fallen 22%, which means that Joe Six Pack’s pension may have just lost a fifth of its value. And all of this is happening on the heels of the $700b bailout that was passed last Friday, which should have moved the market up as well, as it was essentially a capital injection and a government promise to buy up poisonous mortgage-backed assets. So now we’re left to wallow in our shrunken net worth, and play guess-where-the-Dow-will-bottom-out.
What is the reasoning behind this recent freefall? According to the Wall Street Journal, “this week’s relentless selloff has been driven by deepening fears about the banking system, and the spillover effects it may have on the rest of the economy.” So, the market did not mysteriously tank on Thursday because something fundamentally bad was uncovered; it tanked because we think something bad is going on, and our thinking that it’s bad has just made it worse. We might be right, or we might be wrong–either way, it’s like we’re saying that the milk has spoiled because everyone thinks it will spoil, or that the car won’t start because everyone believes that a nicked-up car can’t run anymore. Thursday shows us that reason has taken a backseat, and our questions, fears, and now lack of greed are just leading to greater volatility and uncertainty. Furthermore, this dangerous, immeasurable force of fear also has huge implications on what the Fed, the Treasury, and Congress can do to solve this crisis. If the market won’t act rationally to potential solutions, then what’s the point?
Many in the finance industry would likely agree that our world seems fundamentally different than it was even just a week ago. Pretty soon, 1+1 might not equal 2 anymore… instead, it’s whatever we think it is. Any guesses on what that might be?
