A Superlative Week

It was the best of times, it was the worst of times…it was simply a superlative week. Highs, lows, record moves and of course a healthy dose of hope, fear and dashed expectations were the highlights. It is indeed understandable if you are a bit unnerved by the roller coaster action of the week.

Last Monday, US stocks saw their biggest one-day percentage gain (11-12%, depending on the index) since the Great Depression on the heels of the government’s historic plan to restore confidence and strengthen the US banking system. By Wednesday, the plan lost luster as investors quickly shifted from systemic fear to the problems that exist in the core economy. As a result, stocks had the biggest one-day percentage loss since the Crash of 1987. In between, volatility, as measured by the VIX, reached its highest level EVER. By the end of the week, most were happy that it was just over and some may have noticed that stocks were higher for the first week in five. In fact, it was the Dow’s best weekly gain since March, 2003 and the first weekly gain since Lehman Brothers collapsed, but that is tempered by the fact that it followed the worst week ever for the Dow, which ended the previous Friday (Oct 10) with the lowest close since April 2003.

A Victorian commentator once noted that “Every genuine business panic springs from the same root, which is rank speculation.” Add to that idea that every panic is marked by a sense that the financial system is close to complete collapse and you can guess that the unwinding of speculation becomes super-charged when fear is added to the equation. These are times when loss aversion supplants profit potential as the dominant investor motivator.

In other words, the inverse of a speculative boom is a fear-driven panic, when as Edward Chancellor in the Financial Times, (10/14/08) noted that “excessive confidence is replaced by extreme fearfulness and a nervous distrust takes the place of blind trust.” Or as James Stewart noted in the Wall Street Journal, a panic resembles a bubble: “Just as in a bubble, price/earnings ratios were now irrelevant, because earnings were going to be so much lower than forecast. (In a bubble they're going to be higher.) People were saying confidently that the Dow Jones Industrial Average was going to 6000. (It was 20000 in the bubble.)”

In times of extreme price action, I always come back to the same theme: there are two dominant emotions in this business: fear and greed. For the sane investor, the challenge is to avoid getting caught up in either extreme. On the way up, you need to shut down the cheerleaders, stick to your game plan and not get sucked into buying the speculative top of any asset class. Conversely, on the way down, you need drown out the Cassandras, adhere to your long-term strategy and not get suckered into selling the fear-based lows. This does not mean that you should not adjust your portfolio as conditions change, but not succumbing to extreme emotions is likely to keep you out of trouble, especially during superlative weeks.