Down Dows and Cognitive Dissonance

On October 19 I posted a comment about the relevance of cognitive dissonance to the equity markets. Investors were nervous because of conflicting information about the extent of the subprime losses. John Tierney has since written about cognitive dissonance in the NY Times in a non-Wall Street context. What I said last month seems to apply with two more 300+ declines in the Dow through yesterday and could help explain the wild ride today.

The dissonance (the word disconnect works just as well, if you prefer) has been between two types of signals. One is the large writeoffs by Wall Street firms of losses in subprime loans and related assets. The other is the continuing expansion of the extent of the losses, like the 13th cuckoo that calls into question the ones that have come before. Or, as a Wall Street trader put it to me at noontime yesterday as we were listening to Fed Governor Kevin Warsh: "The equity markets have been saying one thing and the fixed-income markets another. They can't both be right." Traders make their living by surgically eliminating their preconceptions based on new truth and making swift moves in advance of other investors.

The fixed-income markets yesterday were at their most bearish since August, while the Dow has been declining more gently. Equity investors perhaps hang on in the hope that the latest Dow drop is the last, or that another cut in the Fed target rate is in the wings, like cavalry imagined coming over the hill. Or stockholders or mutual fund buyers have given up trying to time their exit from the equities that they own. Professionals are more wary of "catching a falling knife" by acting too early on the belief that the bad news has ended. I remember in the summer of 2000, after the disastrous March decline of the prices of dotcom stocks, someone was attempting to sell shares in a bottom-fishing hedge fund that would pick up dotcom bargains. Well, the dotcom basement had a sub-basement and even a level B and C below that, as we found out in November 2000 if not before.

The fast-growing Royal Bank of Scotland, the world's fifth-largest bank, takes a surprisingly dim view of how much more in the way of losses remains to be declared. Its chief credit analyst, Bob Janjuah, estimates subprime losses and new accounting requirements (FASB 157, effective Nov. 15, which will make it harder for Wall Street accountants to mark hard-to-value illiquid "Level 3 assets" to what Janjuah calls "make-believe") will bring cumulative writedowns in the $250-$500 billion range. Up till now we have seen at most $50 billion acknowledged. So either RBS overestimates or the capital markets still have significant adjustments to make.

As of the early afternoon today the bears were out in force after Fed Chairman Ben Bernanke testified to Congress that he expected the economy to "slow noticeably" in the fourth quarter and that higher inflation could be caused by rising commodity prices and a weaker dollar. Bernanke said that this difficult combination of affairs (stagflation) would probably be temporary. The Dow was down about 180 points by the early afternoon and the NASDAQ fell 3.3 percent. By the end of the trading day, however, the S&P 500 index and the Dow were only slightly negative. The mostly smaller and riskier NASDAQ stocks, however, shed about 1.9 percent of their value.