The State of Confidence

If you think about it, the stock market’s reaction to the bursting of the internet bubble in 2000 was different from the reaction currently being witnessed. Whilst I do not want to discuss financial differences between previous and current markets, I would like to talk briefly about differences in terms of behavioral finance.

In my opinion, during the bubble, investors were putting their “highest risk assets” into various technology/upcoming companies. By “highest risk”, I mean assets that were not needed for essentials, and with which individuals were willing to take risks. Most investors knew that there was a fair amount of risk investing in 100 P/E companies, but they were interested in riding a wave that (seemingly) was going to continue for some time. As a result of this acceptance, their confidence in the system was not drastically harmed when the bubble did burst and the markets came crashing down (although their wallets were).

More recently, people investing in AAA obligations (CDOs etc…) were putting their “lowest risk assets” into the market. The securities were “supposed” to be relatively risk-free and inherently safe; acceptance of risk was extremely low. Therefore, when the markets suddenly dropped and investors saw their AAA ratings become irrelevant, a much more fundamental change took place. The result of the current market decline is that people have lost a lot more than money: they have lost confidence.

The reason this is extremely interesting relates to the causal effect it will have on the eventual recovery of the market. As Lord Keynes describes in the 12th Chapter of his classic “The General Theory of Employment, Interest and Money”:

The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not analysed it carefully and have been content, as a rule, to discuss it in general terms. In particular it has not been made clear that its relevance to economic problems comes in through its important influence on the schedule of the marginal efficiency of capital. There are not two separate factors affecting the rate of investment, namely, the schedule of the marginal efficiency of capital and the state of confidence. The state of confidence is relevant because it is one of the major factors determining the former, which is the same thing as the investment demand-schedule.

A collapse in the price of equities, which has had disastrous reactions on the marginal efficiency of capital, may have been due to the weakening either of speculative confidence or of the state of credit. But whereas the weakening of either is enough to cause a collapse, recovery requires the revival of both. For whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition.”

Although this was written over 70 years ago, it very much applies to the current state of affairs. Only when ‘the state of credit’ and ‘speculative confidence’ converge upward will the market begin to recover. Unfortunately, with economic conditions continuing to worsen as we move deeper into this recession, it appears as though we are a long way from confidence being reinstated. And until it comes back, the markets will not be able sustain a recovery, even if credit crisis indicators continue to improve. This is something to think about before investing, and should reinforce the importance of having a large margin of safety if you chose to do so. For the average investor, it is better to be late to the party and right, than early and dead wrong — especially when the market is this volatile. Note: All of the above relates very much to Behavioural Finance. In strict financial terms, there are a wide array of factors contributing to a recovery.


~ by eboro on November 13, 2008.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: