Psychology is not allowing what the economics textbook says should happen to actually happen

2008-10-9

Psychology is not allowing what the economics textbook says should happen to actually happen

Markets continued to resemble a listing ship in a storm, with officers furiously bailing water but unable to control when the punishing wind and rain will pass. The storm just has to do that on its own.

Officials around the world have taken unprecedented steps recently to shore up the global financial system, but confidence remains low and, according to many analysts and traders, that has become an increasingly self-fulfilling problem largely beyond officials’ control. Each day’s stock-market drop sparks worries that fuel the next’s, and each day of high borrowing costs between banks is interpreted as evidence that risks remain high, which props up the next day’s rates.

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That stomach-churning pattern continued Thursday as an early 190-point rally in the Dow Jones Industrial Average evaporated, leaving the blue-chip measure on the verge of a seventh straight daily loss. It was down more than 300 points in recent trading, falling below the 9000 mark.

The Dow has plunged nearly 15% during its losing streak so far, and is down 35% from its record finish a year ago.

Peter Cardillo, chief market economist at Avalon Partners, said the 9000 level, could prove to be an important testing ground for whether the broader crisis of confidence has run its course. If the market holds there, as Mr. Cardillo expects it might, the market could begin to build a more sustained rally. But if it breaks through that round number by a significant amount, the bloodletting could continue for days longer, at least.

“It’s getting to a point where it’s every man for himself,” said Mr. Cardillo. “When fear reaches that level, you’re getting close to a bottom. But we’re clearly not there quite yet.”

Among the Dow’s components, General Motors shares were down by 15% in recent trade.

Analysts said that trading has been marked by skepticism that recent actions by regulators world-wide are adequate to stanch the credit crisis. Investors aren’t yet convinced that vast sums of government money will convince banks to start lending again.

“Psychology is not allowing what the economics textbook says should happen to actually happen,” said strategist Doug Peta, of the New York portfolio-management firm J. & W. Seligman & Co.

In particular, Mr. Peta and other Wall Street pros say the stock market is unlikely to make a sustained rebound until the interbank-lending market loosens – a scenario that remained elusive despite Wednesday’s global rate cut and speculation that more easing may be on the way.

According to data from the British Bankers’ Association, overnight U.S. dollar Libor fell to 5.09375%, against Wednesday’s fixing of 5.375%. But longer-term funding pressures tightened. The key three-month Libor rate rose to 6.28125% from 6.27125%, and the one-month rate climbed to 6.08688% from 6.075%.

Those rates are key to setting the prices of credit that banks charge their clients, including companies whose activities drive growth in the broader economy.

“Every single business in the world needs working capital,” said Mr. Peta. “You need to spend money to make something before you can sell it, which is what generates your profits, which is what drives the stock market. That’s why the stress in short-term funding is the crux of the market’s problem right now.”

Other major stock yardsticks were lower. The technology-focused Nasdaq Composite Index fell 0.8% to trade at 1727. The small-stock Russell 2000 tumbled 1.9% to 536. The S&P 500 shed 2.1% to trade at 964, led by a decline in its energy sector, off 8%. The S&P financials fell 5%.

Strategist Jim Paulsen, of Wells Capital Management in Minneapolis, said the fear that has gripped the market in recent days may be an unintended, self-fulfilling consequence of recent efforts in Washington to pass a $700 billion rescue of firms saddled with soured credit bets.

“To sell the bailout to the public, everyone from the President on down had to go out and tell people how bad everything was, that the world was coming to an end,” said Mr. Paulsen. “Ever since, people’s expectations about the economy have gotten worse and worse and worse, and their reaction to each new action to fix the problems has gotten worse and worse and worse.”

Morgan Stanley was down 20%. The firm has slid recently despite assurances from the company and Japanese investor Mitsubishi UFJ Financial that a capital injection is going through.

“For [Morgan Stanley and GM], it remains credit issues,” said Sveinn Palsson, equity derivatives strategist at Credit Suisse. “People are worried how the credit squeeze is affecting the economy and these companies are at the heart of that.”

Another company highly dependent on free-flowing credit markets — student-loan giant SLM — was lower by 16% in recent trading.

Extreme intraday volatility in the stock market has been scaring away buyers, traders say. Many point to the Securities and Exchange Commission’s ban on short selling of financial stocks — bets made with borrowed stock that prices will decline — as one reason for the big swings. Some traders said that some of the declines in Morgan Stanley and GM, both of which were covered under the ban, could have been due to the ban’s end.

Energy stocks were also weaker amid a continuing decline in crude-oil prices. Chevron, a Dow component, was down by 5% in recent trading. The front-month crude-oil futures contract was down almost two dollars in recent trade, leaving oil just above the $87 a barrel mark. Oil prices have deteriorated as the credit crisis has inflamed worries about a global recession and subsequent drop in demand for fuels.

Other commodity prices have also suffered. The broad Dow Jones-AIG Commodity Index edged down 0.1%.

Long-term Treasury prices fell. The 10-year note shed 1-2/32 to yield 3.785%. The 40-year bond was off 1-16/32, yielding 4.121%.

The dollar strengthened against major overseas rivals. The euro cost $1.3654, down from $1.3667 late Wednesday. One dollar fetched 100.96 yen, up from 99.84 yen.

—Geoffrey Rogow and Rob Curran contributed to this article

Write to Peter A. McKay at peter.mckay@wsj.com.