Another Black October? It's All in the Mind

October 19th marks the 20th anniversary of the 1987 stock market meltdown , a panic whose causes still puzzle the pundits. Need a good briefing on the horrendous event? See Matthew Rees's article in The American:

For the preceding seven weeks, the stock market had been skidding. Now, on this sunny Monday, it was on the verge of total collapse. When the day was over, the Dow Jones Industrial Average had lost more than 500 points, or 22.6 percent of its value—the equivalent of a drop of about 3000 points today. A half-trillion dollars in wealth disappeared overnight—equivalent at the time to the entire gross domestic product of France. On the heels of the decline, a recession was considered a near certainty and a depression a distinct possibility.

But there was no recession. In a few months stock prices started to recover. It was as if Gilda Radner had returned to the Not Ready For Prime Time Players, thrown a terrifying, tumultuous tantrum, wailed that the world was coming to an end, then smiled . . .

"Never mind."

Psychology drives market panics. That's what makes them so puzzling. You can tell when the herd is starting to feel restless, but nobody knows what might trigger a stampede.

This year the sub-prime mess has bred new fears of recession. Could a slump be prefaced by another Black October? Are today's hedge-fund managers less likely to stampede than all those investment pros who panicked twenty years ago?

Recessions, economist Robert Shiller writes in a NY Times op-ed piece, are also a matter of psychology, not facts and figures:

[S]alient, emotion-arousing narratives — those that capture the popular imagination and damage public confidence — are central to the etiology of recessions. As these stories gain currency, they impel people to curtail their spending, both in business and their personal lives.

Is this happening now? A disturbing narrative began to unfold in the last couple of months. People began talking of failed institutions — of the possibility that savings socked away in a money market account might actually be invested in subprime loans and so be lost. There has been fear of locked credit markets, of possible bank failures and runs on banks.

Some of these tales have faded — bank runs no longer seem a risk. But confidence in the economy remains fragile. More shocks are likely as an era of huge real estate speculation apparently ends, with the possibility of further surges in foreclosures and failures of financial institutions.

The narrative is still unfolding, and the extent of its virulence is not yet known.

Last summer's minor market glitches were enough to disturb many investors. How would they react to a sudden 3,000 drop in the Dow?