DOWN DOWS | Cognitive Dissonance

Oct. 19, 2007–For the day, the Dow fell 367 points or 2.6 percent to 13,522. For the week, the Dow was down 4.1 percent. The other indexes fell by similar percentages. The day had little specific news to drive it. Initial news-service analyses didn’t make much sense, explaining the downdraft based on a few isolated weak earnings reports. The heavy buying of Treasury notes made clear that something more basic was going on – investors were worried and were looking for a safe haven, desperate not to be caught with what they were selling after the market closed on Friday.

Can we explain the week’s drop in the market? Here are two lines of thinking:

1. Investors applied rational expectations theory. The financial community has been providing a stream of information about the subprime loans and some of the information creates cognitive dissonance. Investors take into account all information available and some of the information doesn’t compute. The fact that the FOMC lowered the target interest rate preemptively by 50 points was initially seen as an effort to spur the economy. In retrospect, it can also be seen as an indication of worry on the part of the Fed about credit markets. After the major banks took heavy writeoffs for subprime loan losses, three of them got together to try to bolster the market for structured investment vehicles with a so-called Master Liquidity Enhancement Conduit. This $75 billion conduit raised more questions than it answered. Former Fed Chairman Alan Greenspan opined that the special fund might be counterproductive, contributing to rather than reducing worries about possible further losses. Further losses in the credit markets can be expected to exacerbate problems in the real estate arena, lowering values and discouraging new construction.

2. The madness of crowds and the power of superstition. Today is the 20th anniversary of Black Monday, when the Dow fell 22 percent. The Armenian genocide resolution in the House of Representatives started up a round of international hand-wringing that has raised difficult questions of alliances and allegiances. Turkey is an important friend of Israel as well as the United States. New sabers are rattling in Turkey and Iraq, including a threat by the Kurdish rebels (the PKK) to destroy pipelines carrying oil into Turkey. Add that to a seemingly endless series of U.S. current-account deficits, U.S. budget deficits, declines in the value of the dollar, and a new shifting out of dollars by Asian central banks and it would be easy to see how fears might begin to mount.