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Generational Dynamics Web Log for 13-Sep-07
By one measure, investors are getting increasingly anxious and worried

Web Log - September, 2007

By one measure, investors are getting increasingly anxious and worried

Even though everything seems very calm right now, the levels of investor anxiety and panic have been increasing steadily all year.


The Marketpsych Fear Index versus the Dow Industrials, Jan-Sep 2007 <font face=Arial size=-2>(Source: WSJ)</font>
The Marketpsych Fear Index versus the Dow Industrials, Jan-Sep 2007 (Source: WSJ)

The adjoining graph appeared in a Wall Street Journal article on the emotional roller coaster that investors currently face. "In these markets, everyone's afraid. It's your response to the fear that matters most."

According to the article, people respond from a different part of the brain when in the midst of calm, clear thought. "That area is the prefrontal cortex, ... the "executive" node of the brain that plans and reasons. When we are fearful, blood flows away from the area toward the motor areas of the brain -- the ones that produce a flight-or-fight sensation. This is great if you're confronting a saber-toothed tiger, but not so great if you're mulling your daughter's college fund."

If you look at the above graphic, you'll see that it graphs two sets of values: The DJIA index (in blue), and the "Marketpsych Fear Index" (in gold)." The point of the graph is that the market index was lowest when the "fear index" spiked up, after the February 27 and July 23 "mini-panics."

However, the article never mentions this or anything else about the graphic.

This is very strange about the article. It contains all kinds of fuzzy advice about good investing practices when you feel panicky:

"He recommends two other means of coping with financial fear. The first sounds simple but is essential -- training yourself to recognize fear in the first place. For example, your habit may be to avoid the markets altogether by shunning the newspaper or online stock quotes.

The second approach is to prepare for a busted or volatile market, much like an astronaut rehearsing emergency procedures. This helps neutralize the fear in your decision making, especially in those moments when it seems so easy to succumb.

That's why it might make sense to decide ahead of time your range of responses if your portfolio loses, say, 10% to 20% of its value. Research has shown that, unsurprisingly, retail investors are usually the worst at this, adds [MIT Professor Andrew Lo]."

That's probably good advice, but what we're interested in here is examining the behavior of the market as a whole.

I'm guessing here, but there's little doubt in my mind about why there are no comments about the graph: The news is very bad.


The Marketpsych Fear Index versus the Dow Industrials, Jan-Sep 2007, annotated with trend line <font face=Arial size=-2>(Source: WSJ)</font>
The Marketpsych Fear Index versus the Dow Industrials, Jan-Sep 2007, annotated with trend line (Source: WSJ)

The modified graphic shows the trend line since the beginning of the year, ignoring the two "mini-panics." The transparent red line shows that the "fear index" has been trending upwarding continuously all year, even if you ignore the spikes.

From the point of view of Generational Dynamics, this provides a great deal of interesting new information.

As regular web site readers are aware, I've been conducting a speculative real time experiment, comparing the 1929 and 2007 markets, following their respective market peaks. In 1929, the Dow Industrials peaked on September 3 at 381.17; within 8 weeks, it had fallen 40%. In 2007, the market peaked on July 19 at 14000; 8 weeks have now passed, and the market is 5% below its peak, and may drift even higher. So the comparison seems to have failed.

There IS one major difference between today's market and the 1929 market: The aggressive "injection" of liquidity into the markets. This action has so far prevented a "domino effect," where the collapse of one investment vehicle causes others to collapse. This is serving to extend the period of time over which the financial crisis occurs.

However, this "fear index" study, if valid, indicates that the fundamental basis on which the comparison was made is correct.

Recall that I've said that it isn't the market ups and downs that matter; what matters is the level of fear and anxiety exhibited by masses of investors.

The graph shows that investor anxiety has been growing steadily since January, not just since the July 19 peak, as I had been assuming. It would be very interesting to have data prior to January, but the Marketpsych web site doesn't seem to provide any earlier data.

The WSJ article concludes with these paragraphs:

"Each generation has to go through it and has to emotionally experience it," [says 67-year-old financier Lewis van Amerongen]. "Without that, it's just an academic exercise."

In other words, there is no substitute for having survived other fearful experiences. The best antidote for fear just may be fear itself."

This concept is what this web site and Generational Dynamics are all about. When a generation survives a generational crisis war or a generational financial crisis, they learn how to deal with these crises, and they don't panic.

The generations born after the crisis don't have that experience under their belts, and they DO tend to panic.

As long as the surviving generations are alive, they're society's leaders, and they can control panic. That's why generational crisis wars have never occurred in the 40 year period following the end of one crisis war, and have rarely occurred in the 50 year period following.

Once the surviving generations disappear, the younger generations have no experience and no leadership that helps them deal with panic. This is what leads that next generation into the next crisis war or the next financial crisis.

Assuming that I can ever find anyone who's interested in funding Generational Dynamics research, the "fear index" study hints at a very powerful predictive tool. A "fear index" can be computed for many different things -- not just financial market anxiety, but also anxiety in Palestinians over Israelis, anxiety in Israelis over Palestinians, or anxiety in Americans and Chinese about each other.

Let me just tie this into things I've written about many times in the past:

These examples indicate how the "fear index" can be used in a variety of ways to augment the Generational Dynamics forecasting methodology.

This "fear index" can even be computed for several prior years, by examining news stories and even blogs during previous years.

This kind of study could be a powerful business tool -- by measuring anxiety in specific markets, for example -- and a powerful international relations tool -- by measuring anxiety between potential war enemies.

The "fear index" would be a short-term forecasting tool, of a type that I've previously discussed. As I've indicated in the past, the Generational Dynamics forecasting methodology combines long-term and short-term forecasting methodologies. The long-term forecasting tools provide predictions that are 100% accurate, but within a window of years and sometimes decades. Short-term forecasting methodologies produce predictions in the very near term, but rarely with a probability much above 50%. What I've been doing on this web site for 5 years is developing the forecasting methodology that combines short-term and long-term forecasts into a forecast that has an 80-90% probability of being correct, and with a window of just a few weeks or months.

As I write this, early on Thursday afternoon, the market appears to be surging upwards. The commentary is related to the "certainty" that Fed is going to decrease the Fed funds interest rate when it the Open Market Committee meets next week, and that this decrease will save the world. The expectation is that the Fed will reduce the Fed Funds rate by 25 basis points (% interest), from 5% to 5% even.

The following graph, appearing on the Minyanville blog, shows the EFFECTIVE Fed Funds rate:


Effective Fed Funds Rate, Jan-Sep 2007 <font face=Arial size=-2>(Source: Minyanville)</font>
Effective Fed Funds Rate, Jan-Sep 2007 (Source: Minyanville)

What's the EFFECTIVE Fed Funds rate?

If you go back to my recent article, "Bernanke's historic experiment takes center stage," I described how the Fed uses "open market operations" to provide INDIRECT control over the interest rate that banks use when lending money to one another. This indirect control is not absolute. As you can see from the above graph, the EFFECTIVE rate was very close to 5.25%, the nominal rate, since January.

However, right after the July 19 market peak, the credit crunch began in earnest, and banks started "hoarding cash," for fear that they'd have cash flow problems. They demanded that the Fed sell them a lot more Treasury bills than usual, since the banks wanted to lend their excess cash to the Fed, rather than to each other. The Fed evidently acquiesced to these demands, sold more Treasury bills than usual. The demand for these bills was very high, and so the price went up, pushing the yields, or interest rates, down. (Prices and yields vary inversely.)

The graph above shows that the Fed Funds rate has been EFFECTIVELY around 5% for much of this period, and so an OFFICIAL lowering of the Fed Feds rate to 5% should not have a great effect.

That's why a Fed Funds rate reduction next week is so widely expected, and it's also why it may not have much of an effect.

But there's nothing rational about what's going on. Investors remember that the party was still in full force (i.e., the bubble was still growing) when the Fed Funds rate was last at 5%, and so they expect it to have the same effect now.

Actually, there are a lot of negative indicators that weren't in play the last time the Fed Funds rate was at 5%: the value of the dollar has fallen to record lows against the euro; unemployment claims have been growing steadily all year; oil prices have surged to $80 a barrel.

And possibly most important, the "Marketpsych Fear Index" has been growing steadily and relentlessly all year, and there's no reason to believe that will change. In fact, it's generational change that's causing the growth, and nothing can change that.

From the point of view of Generational Dynamics, the fundamentals haven't changed from where they've been for several years. A stock market panic and crash MUST occur, because the market overpriced by a factor of 250%. The behavior that the "fear index" captures is the dramatic change, for masses of investors, away from "risk-seeking" or "risk-ignoring" behavior toward "risk-averse" behavior. Unless there's an equally dramatic reversal of investor attitudes and behaviors, it's still likely that this will occur in the next few weeks. (13-Sep-07) Permanent Link
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