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How could a microscopic organism destroy nearly $15 trillion in global stock-market wealth in five weeks?
Until recently, many investors believed central banks and other policy makers had repealed the business cycle and that making money in the stock market was something you could take for granted—in much the same way that science and technology seemed to have beaten back diseases that had been the scourge of humanity for millennia.
Maybe investors a century ago and more had a wiser view. They believed the world was governed by unseen, omnipresent powers that could be appeased but never controlled—and that financial panics were a form of divine retribution for the sinful excesses of prosperity.
We shouldn’t regard market panics as quaint artifacts from the days of ticker tape and trading by telephone. Rather, they are forces that can be hidden or delayed but never eliminated. And believing that panics have become obsolete is a precondition for their recurrence.
The modern history of financial markets is a chronicle of attempts to control risk—if not eliminate it. One after another, they have all failed.
ILLUSTRATION: Michael Haddad, WSJ
The downturn of 2020 could rival market pullbacks during past contractions but is far from the lows reached during the Great Depression.
Crash landing
“We trust these brilliant innovators in finance who seem to know what they’re doing when they try to control risk,” says Yale University economist and financial historian William Goetzmann. “And then, lo and behold, the risk mitigation doesn’t happen.”
The Federal Reserve was created in the wake of the Panic of 1907 to mitigate the risk of financial meltdowns.
Some thought the problem could be solved. As the stockbroker DeCourcy W. Thom proclaimed in his postscript to economist Clement Juglar’s “A Brief History of Panics” in 1916: “Just as modern medicine is overcoming the dangers threatening the physical man, so is modern finance overcoming panic and the other dangers which threaten financial stability.”
He was wrong—as similar forecasts have been ever since.
The Fed failed to stave off the crash of 1929 and, by not expanding the money supply in the early 1930s, probably worsened the Great Depression.
In the mid-1980s, a computerized hedging technique called “portfolio insurance” purported to limit losses for big institutional investors; it ended up being partially blamed for the crash of 1987.
In the mid-2000s, financial engineers created ever-more-complex derivatives as a way of carving up and spreading risk. That, Federal Reserve Chairman Alan Greenspan said in 2005, “contributed to the stability of the banking system” by allowing participants “to measure and manage their credit risks more effectively.”
But risk can’t be removed; it can only be moved. The techniques hailed by Mr. Greenspan may have caused the financial crisis of 2008-09 by making bankers and investors so complacent that they never sufficiently tested whether their assumptions might be wrong.
Some economists are now predicting a pullback in gross domestic product that would rival the severity of the 2008-2009 slump.
Contraction calculation
Finally, in the run up to the latest panic, many investors seemed to believe index funds and exchange-traded funds, which can offer broad diversification at extremely low cost, had somehow eliminated the risk of owning stocks.
Our forebears, on the other hand, believed panics are the indispensable hygiene of markets, sweeping the investing landscape clean after every orgy of prosperity.
That notion was captured brilliantly by the illustrator Frank Bellew in a cartoon for New York’s “The Daily Graphic,” days after the onset of a market panic in 1873. An ugly giant straddles the street, sweeping up clouds of dirt and shreds of ticker tape labeled “BOGUS BROKERS,” “SHAKY BANKS” and “ROTTEN RAILWAYS.” He wears tattered goatskins, his hair tangling into horns as it rises from his scalp.
The caption reads: “Panic, as a Health Officer, Sweeping the Garbage out of Wall Street.”
Bellew personifies Panic as the god Pan, who haunted the countryside of ancient Greece. Half-goat, moody and mischievous, Pan was the god of herds, manipulating them with the music from his pipes. He lurked in mountain caves, arising at midday to burst out of nowhere at startled travelers.
No wonder the ancient Greeks called a sudden fear “panikos.” It came from Pan.
He was also the god of fertility. And financial panics, through the ensuing upheaval, fertilize old ground for new competitors and transfer assets to those who can put them to their best use.
Out of the boom and bust in wooden turnpikes in early 19th-century New England came the rights of way that railroads later followed with ease through the forests and fields. Out of the mania for technology stocks that collapsed in 2000-02 came the glut of fiber-optic networks that make instant communication universal and cheap as dirt today.
It's not yet clear if unemployment will surpass the jobless rates reached during the longest recessions since the Great Depression.
Looking for work
The U.S. and British economies “cannot subsist without sowing the wind and reaping the whirlwind of a financial crisis two or three times in each generation,” wrote the financial journalist Horace White in 1876. Financial crises, said White, recurred with “the regularity of clock-work, so that people pretend to know when to expect one by looking in the almanac.”
The early U.S. suffered severe financial panics roughly once every 13 years on average, in 1792, 1819, 1826, 1837, 1857, 1873, 1884, 1893 and 1907.
People used to regard booms and busts as part of “an organic cycle of life,” not as outcomes that can be prevented or controlled, says Mr. Goetzmann of Yale.
In that organic cycle, entrepreneurs who think business conditions will improve “become centers of infection, and start an epidemic of optimism,” the economist Wesley Clair Mitchell wrote in his 1913 book, “Business Cycles.” That optimism leads to a “flood tide of prosperity,” which washes away caution, creating euphoria that culminates in a crash—which, in turn, clears the way for recovery. Lather, rinse, repeat.
In recent decades, psychologists have shown that people tend to overweight recent experience in their predictions of the financial future. Because markets rise more often than they fall, the experience of most investors tends to be positive over time. The longer the good times roll, the more remote the chance of a decline will seem, the more overconfident investors will feel and the more risk they will take.
Only lately has that euphoria not seemed sinful.
An early panic on the Amsterdam stock exchange was a natural consequence of the preceding bull market, when caution was “called foolishness, madness and crime,” wrote the pamphleteer Joseph Penso de la Vega in 1688. “The spirit of Ahab and Satan” had enticed speculators to join in the “jubilation” of soaring prices.
How could a microscopic organism destroy nearly $15 trillion in global stock-market wealth in five weeks?
Until recently, many investors believed central banks and other policy makers had repealed the business cycle and that making money in the stock market was something you could take for granted—in much the same way that science and technology seemed to have beaten back diseases that had been the scourge of humanity for millennia.
Maybe investors a century ago and more had a wiser view. They believed the world was governed by unseen, omnipresent powers that could be appeased but never controlled—and that financial panics were a form of divine retribution for the sinful excesses of prosperity.
We shouldn’t regard market panics as quaint artifacts from the days of ticker tape and trading by telephone. Rather, they are forces that can be hidden or delayed but never eliminated. And believing that panics have become obsolete is a precondition for their recurrence.
The modern history of financial markets is a chronicle of attempts to control risk—if not eliminate it. One after another, they have all failed.
Crash Landing
The downturn of 2020 could rival market pullbacks during past contractions but is far from the lows reached during the Great Depression.
“We trust these brilliant innovators in finance who seem to know what they’re doing when they try to control risk,” says Yale University economist and financial historian William Goetzmann. “And then, lo and behold, the risk mitigation doesn’t happen.”
The Federal Reserve was created in the wake of the Panic of 1907 to mitigate the risk of financial meltdowns.
Some thought the problem could be solved. As the stockbroker DeCourcy W. Thom proclaimed in his postscript to economist Clement Juglar’s “A Brief History of Panics” in 1916: “Just as modern medicine is overcoming the dangers threatening the physical man, so is modern finance overcoming panic and the other dangers which threaten financial stability.”
He was wrong—as similar forecasts have been ever since.
The Fed failed to stave off the crash of 1929 and, by not expanding the money supply in the early 1930s, probably worsened the Great Depression.
In the mid-1980s, a computerized hedging technique called “portfolio insurance” purported to limit losses for big institutional investors; it ended up being partially blamed for the crash of 1987.
In the mid-2000s, financial engineers created ever-more-complex derivatives as a way of carving up and spreading risk. That, Federal Reserve Chairman Alan Greenspan said in 2005, “contributed to the stability of the banking system” by allowing participants “to measure and manage their credit risks more effectively.”
But risk can’t be removed; it can only be moved. The techniques hailed by Mr. Greenspan may have caused the financial crisis of 2008-09 by making bankers and investors so complacent that they never sufficiently tested whether their assumptions might be wrong.
Contraction calculation
Some economists are now predicting a pullback in gross domestic product that would rival the severity of the 2008-2009 slump.
Finally, in the run up to the latest panic, many investors seemed to believe index funds and exchange-traded funds, which can offer broad diversification at extremely low cost, had somehow eliminated the risk of owning stocks.
Our forebears, on the other hand, believed panics are the indispensable hygiene of markets, sweeping the investing landscape clean after every orgy of prosperity.
That notion was captured brilliantly by the illustrator Frank Bellew in a cartoon for New York’s “The Daily Graphic,” days after the onset of a market panic in 1873. An ugly giant straddles the street, sweeping up clouds of dirt and shreds of ticker tape labeled “BOGUS BROKERS,” “SHAKY BANKS” and “ROTTEN RAILWAYS.” He wears tattered goatskins, his hair tangling into horns as it rises from his scalp.
The caption reads: “Panic, as a Health Officer, Sweeping the Garbage out of Wall Street.”
Bellew personifies Panic as the god Pan, who haunted the countryside of ancient Greece. Half-goat, moody and mischievous, Pan was the god of herds, manipulating them with the music from his pipes. He lurked in mountain caves, arising at midday to burst out of nowhere at startled travelers.
No wonder the ancient Greeks called a sudden fear “panikos.” It came from Pan.
He was also the god of fertility. And financial panics, through the ensuing upheaval, fertilize old ground for new competitors and transfer assets to those who can put them to their best use.
Out of the boom and bust in wooden turnpikes in early 19th-century New England came the rights of way that railroads later followed with ease through the forests and fields. Out of the mania for technology stocks that collapsed in 2000-02 came the glut of fiber-optic networks that make instant communication universal and cheap as dirt today.
Looking for work
It's not yet clear if unemployment will surpass the jobless rates reached during the longest recessions since the Great Depression.
Investors were frantic in 1720 as shares in the South Sea Co. soared and then crashed in London. Only God could restore them to sanity, Jonathan Swift wrote the next year in his poem “Upon the South-Sea Project”:
“May he, whom Nature’s Laws obey,
Who lifts the Poor, and sinks the Proud,
Quiet the raging of the Sea,
And still the Madness of the Crowd.”
Investors in ages past didn’t believe that the stock market was efficient. They thought it was—and always would be—a whirlwind of emotion.
“Wall Street is as much the natural field for panics as the prairie is for tornadoes,” said the financier John Ferguson Hume in his 1888 book “The Art of Investing.”
People then understood what we have forgotten: When you look into a bubble, what you should see in that mirrored surface is yourself.
After all, it isn’t investments that make or lose money; it is investors, with our own excesses of greed and fear. And that means market panics aren’t a time for reaction; they are a time for introspection.
So ask yourself: Have I been taking more risk than I realize? Conversely, how should I turn panic into opportunity? How can I improve my portfolio and restore a sense of control? Should I sell some stocks or funds to generate a tax loss I can use to offset gains or income? Do I have long-held mediocre or risky stock positions I’ve been reluctant to dump until now because that would have generated a taxable gain I’d no longer incur at today’s prices?
Blind faith in tools for controlling financial risk has never made sense. If risk could ever be eliminated, investors would immediately turn so euphoric that they would drive the prices of financial assets sky-high— thereby creating an enormous new risk out of the absence of all the old ones.
Investors should never stop trying to manage their risks. But they should never believe that they, or anyone else, can eliminate them.