How stocks go from seesaw to spiral

THE FINANCIAL PAGE

By James Surowiecki

updated 7:33 p.m. ET Oct. 27, 2008

“Death by a thousand cuts.” “Fire-sale liquidation.” “A vortex of selling.” No matter how people described the market collapse that hit a month ago, the message was the same: It felt like there was nowhere to go but down, and it felt like we’d be going there forever. (Given last week’s dip, it still does.)

Beginning on Sept. 29, the U.S. stock market fell on nine of the next 10 trading days, plummeting 26 percent; then, after a short, sharp rally, it lost 10 percent more in less than two days. Explanations for the crash often focussed on the hysteria and panic that periodically seem to seize investors. But the madness of crowds wasn’t the whole story.

In a healthy market, there are countercyclical forces — mechanisms and institutions that go against the general market trend and encourage diversity of thinking — that make it harder for feedback loops and vicious cycles to take hold. Lately, though, many of these institutions and mechanisms have become procyclical: Instead of countering trends, they amplify them.

Take, for instance, the credit rating agencies, which investors rely upon for evaluations of companies’ creditworthiness and general financial well-being. They are supposed to be a kind of early-warning system for investors, evaluating the health of companies in a way that’s insulated from prevailing market trends. Yet many studies have found that rating agencies are more likely to upgrade companies when investors are bullish and downgrade them when investors are bearish. This makes rating changes less useful to investors and also means that they push the market in the direction it’s already going.

On Oct. 9, Standard & Poor’s announced, late in the day, that it was considering downgrading GM. That helped an already shaky market fall 4 percent in the final hour of trading.

Wall Street analysts have also been good at pouring gasoline on a raging fire. Analysts’ ability to take the long view and scrutinize company fundamentals should make them a counterweight whenever investors get too giddy or too gloomy. And sometimes it works that way: Last fall, when investors were still relatively optimistic about banks, Oppenheimer’s Meredith Whitney correctly forecast serious trouble for the industry.

More often, though, we see what the UCLA finance professor Bradford Cornell calls “positive feedback between stock price movements and analyst recommendations.” In other words, analysts often end up following the market, rather than leading it. In the case of a sell-off, this tends to make a bad situation worse.

Earlier this month, Goldman Sachs downgraded steel companies like AK Steel. A bold call, you might think, except that it came only after AK Steel’s stock had fallen nearly 75 percent in two months.

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