As signs stay murky, fear itself takes charge

More wild swings on Wall Street

(Brendan McDermid/Reuters)

Stocks continued to bungee jump yesterday, and the story was the same: Strong emotions are driving the markets.

Behind the extraordinary volatility were investors letting fear get the better of them while waiting for the $700 billion government plan to rescue financial institutions to bear fruit. Yesterday, the Dow Jones industrial average took triple-digit swings in both directions before finishing up 401.35 points, or 4.68 percent, at 8,979.26.

"I'm getting a little dizzy here," said Concord investment adviser Jim Weiss. "There's been savage emotions in the market."

For much of the past month, the markets have been driven by fear: first, fear the United States had no plan to rescue the banks, and then, after the decision to invest $250 billion in US banks, fear the cash injection wouldn't be enough to get credit flowing again. The biggest fear is that the financial crisis could mean a prolonged recession with heavy job losses.

"Restoring order to the credit market is crucial, because credit is the fuel that feeds our economic engine," said economist Donald Klepper-Smith, the research director at DataCore Partners in New Haven, Conn., and Martha's Vineyard. "The crisis in the financial markets is really a crisis of confidence - business confidence, consumer confidence, and investor confidence."

There have been some signs this week that investors are trying to check their emotions and refocus on economic data.

Wednesday's report that national retail sales had their biggest drop in years helped propel the Dow down 733.08 points, its second largest one-day point loss ever, wiping out most of its historic 936-point gain Monday. Yesterday's rebound was partly a response to another tumble in oil prices and a steady consumer price index.

"We're getting a lot of data, and the market is trying to sort it out," said Weiss, who is president of the money management firm Weiss Capital Management. "The level of confusion, uncertainty, and panic is close to unprecedented. The market's time horizon, which normally looks six to nine months out, has been reduced to about 36 hours."

While part of the fear in the market has stemmed from tangible data, such as the decline in retail sales for September, at least part has been anticipatory, as everyone prepares for the worst. Manufacturers such as Hartford's United Technologies Corp. and Textron Inc. of Providence have said they're cutting costs in expectation of slowing sales, even though their sales haven't yet slowed.

It recalls the first inaugural address of President Franklin D. Roosevelt, who said, "The only thing we have to fear is fear itself." That was in 1933, in the depth of the Great Depression.

"If you were to read that speech today, either McCain or Obama could give it on their Inauguration Day and every word would be appropriate," said Cornelius Hurley, director of Boston University's Morin Center for Banking and Financial Law and former assistant general counsel to the Federal Reserve Board of Governors.

Hurley said the volatility in the market has been a natural reaction to the uncertainties in the economic landscape. The cash infusion in banks is only the first step in what he called a painful "de-leveraging," a process of repricing hundreds of billions of dollars in overinflated assets, from tract homes to bank portfolios, to their new value. The jitters are likely to continue until that repricing is complete.

In a keynote address to Harvard Business School's Centennial Global Business Summit this week, Lawrence H. Summers, former US Treasury secretary and Harvard University president, described "a vortex of five vicious cycles" threatening the economy, some of which are already being seen.

One trend that has already occurred is falling stock prices, prompting investors to sell stock, pushing prices even lower. Another is bank portfolios losing value, leaving banks with less capital to lend, causing them to lose more value. Still another is slowing economic activity that weakens the financial system, constricting lending and further weakening the economy.

Most alarming is the prospect for a "Keynesian" cycle, named for the British economist John Maynard Keynes, in which less spending leads to job losses, leading in turn to lower incomes and still less spending; and a potential "panic" cycle, in which depositors rush to withdraw money from troubled banks, putting them in more trouble and causing more withdrawals.

"These five vicious cycles have created a situation unlike anything most of us have ever seen," Summers suggested.

Some of the dynamics Summers cited showed up in the deepest point drops of the past few weeks, particularly when hedge funds unloaded large volumes of stock in response to "redemption notices" from nervous investors seeking to pull out funds. In some cases, automated computer programs generated those transactions.

This "forced selling" is a new factor in the market, but one that may persist until capital flows have resumed and the housing market has bottomed out, warned James T. Swanson, chief investment strategist for Boston mutual funds company MFS Investment Management. "The market won't know how to behave until you see some stability in housing, because that's the root of the problem," Swanson said.

Ordinary people aren't likely to be reassured until they see a recovery in the measures that most affect their own lives.

"The generators of economic wealth - stocks, jobs, and housing - are all consolidating at the same time," said Klepper-Smith, predicting a downturn stretching into the second half of next year. "People are starting to recognize that the bailout is not going to prevent a recession. It's going to prevent a recession from getting worse."

Robert Weisman can be reached at weisman@globe.com.