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Investing October 10,
2008, 12:01AM EST

Stock Market Crash: Understanding the Panic

Market psychology experts weigh in on what's feeding the selling
frenzy on Wall Street and when to look for investors' moods to change

Photo Illustration: David Sleight/BW; Photo: Spencer
Platt/Getty Images

by Ben Steverman

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Searching for a way to describe the current stock market
meltdown? Call it the "Panic of 2008."

In the past century, the world has seen countless financial crises,
economic downturns, and market crashes. But the last major event to be called a
'panic' was the Panic of 1907.

If ever it were appropriate to revive the term "panic," this is the time. The
day-after-day declines in the stock market are unprecedented.

The S&P 500, the broad U.S. stock index, has lost 22% of its value in six
trading sessions, from Oct. 2 to Oct. 9. Brian Gendreau of ING
Investment Management points out that the Dow Jones industrial average,
founded in the late 19th century, until this month had never seen six
consecutive daily declines of 1% or more.

Forget Normal

Normally even falling stock markets take a break from time to time, as the
vultures swoop in to pick up stocks at bargain prices.

But now, the market's psychology is anything but normal.

Every time the stock market rallies—as it did on the morning of Oct. 9—"there
are tons of sellers everywhere," says Dave Rovelli, managing director of equity
trading at Canaccord
Adams. "People just want out."

Panic in financial markets—just as in everyday life—is explained by the
fight-or-flight instinct. "That makes people overreact," says Avanidhar
Subrahmanyam, a professor and expert on market psychology at the UCLA Anderson
School of Management.

Not only are stock traders running scared, so are financial institutions.
"You've got panics not only among individual investors but panic in the industry
itself," says John Merrill, chief investment officer at Tanglewood Wealth
Management.

Dysfunction in the credit markets means financial firms lack the confidence
to transact business with each other.

Irrational Despair?

A panic is a "situation in which people do things that contradict
rationality," says Paolo Pasquariello, a professor at the University of
Michigan's Ross School of Business.

But by that definition, is this really a panic? "It's difficult to say people
are selling because they are panicking," Pasquariello says. Selling now isn't
necessarily irrational, he says. There are plenty of good reasons to move from
riskier to safer investments at a time when the financial system has stopped
working and a serious economic slowdown looks imminent to many economists.

By contrast, Subrahmanyam is more convinced the markets are behaving
irrationally. It's not as if we've had a nuclear war and "real" assets were
destroyed, he says. Rather, problems are in the financial sector, not the "real"
activity in the rest of the economy. "The real, nonfinancial base of the economy
is still fairly strong," he says—far stronger than during, for example, the
Great Depression.

Bargain Basement

"Financial panics don't last forever," says ING's Gendreau. Eventually
investors will realize that many assets are trading at deep discounts. "Either
we're going to go into a Great Depression, or some of these assets are trading
at very attractive prices," he says.

Many market participants believe the wave of stock selling is being pushed by
hedge funds and other institutions that must sell assets to raise cash. Often
these assets—from stocks in solid companies to municipal bonds—are being sold
without regard to their inherent value. But, before jumping back in the market,
"You wait for the forced selling to run its course," Merrill says.

So when might this downward spiral end?

Because of our flight-or-flight instincts, Subrahmanyam says, "things are
very quick to crash." But "the recovery takes much longer."

You First

"The market ultimately reaches a bottom," says Georgetown University finance
professor Reena Aggarwal. However, "no one wants to be the first to move. The
markets behave in a herd mentality."

Pasquariello worries governments may simply blame market troubles on panic
and irrationality—"on people being crazy." That gives them the excuse to step in
and try to restore market confidence in artificial ways—such as the its recent
ban on the short-selling of financial stocks, which he opposed. The real reasons
for the financial crisis will "take a long time to fix," Pasquariello warns.

By its nature, a crisis is a time of uncertainty. It could be months before
we know whether markets are crashing because of irrational fear or because of
real economic problems. And that's scary.

Steverman
is a reporter for BusinessWeek's Investing channel.

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