Wednesday, March 16, 2011

The Psychological Stages of the Japanese Crisis

Federal tsunami warning radios bleeped on at 1:40am Pacific time along the West coast of the USA last Friday morning.  The voice coming over the radiowaves reported an earthquake off Japan and gave a tsunami estimated arrival time in Santa Barbara at 8:24am and in Santa Monica at 8:39am.  This was the direct result of the largest earthquake to ever hit Japan, and the fourth largest to strike the earth in recorded history, now listed as a 9.0 on the Richter scale.

That morning TV viewers could see video coverage of a 30 foot wave washing over coastal villages in Japan, to such an extent that entire towns were lifted and crushed by the wall of water.

Given that Japan is the third largest economy in the world, you might think that U.S. traders and investors would rush to sell shares, buy puts, hedge, and reposition.

Nope,  by the close of trading on Friday, the DJIA was up 60 points.

It wasn't until Monday, and again today, that investors realized the full extent of the risks that had emerged.  "What took them so long," is a fair question to ask.  In this post I explain the psychological stages which drive financial markets after catastrophic events such as natural disasters and terrorist attacks.

Stage 1:  Underreaction.  In this stage people don't realize the scope of the disaster.  They believe the stock rally will go on as is, and they believe the government assessment of the situation.
Psychological Driver:  Cognitive Dissonance.  We have trouble processing new information that is out of our comfort zone.  We need time to reconcile it with our established habits and beliefs.

Stage 2:  Reaction.  We realize that all is not good, and we take action.  The Nikkei drops 14% in one day.  The S&P 500 sheds its 2011 gains.  This is occurring early this week.  Fund managers sell the stocks of companies that are likely to be hit, and buy shares of those likely to benefit.
Psychological Driver:  Rational reappraisal.  We incorporate the new facts, and revalue securities accordingly.

Stage 3:  Overreaction.  This is where is gets interesting.  Uncertainty and fear color our assessment of the facts, and we believe we get more information from the market price action (plummeting) than from a rational appraisal of wind currents.  Stocks sell off, Potassium Iodide (KI) sells out off store shelves in California.  People sell their stocks just because others are doing so and prices are dropping, they don't want to be the last ones holding the bag.  This is the "risk-off" trade, where indiscriminate risk selling occurs.  This is occurring today.
Psychological Driver: Fear, uncertainty, and loss of a trusted authority.  Radiation cannot be seen, is widely feared, and may spread beyond Japan.  Perhaps most worrisome to investors, there is no longer a trusted authority who knows the truth - the Japanese goverment appears to either not understand the situation or to be trying to prevent panic by hiding the true impact of events.  All of these factors lead to overreaction - usually occurring about 4-5 days after a crisis, and culminate in panic, when real investment bargains are to be found.

If you're waiting to buy Japanese construction and insurance stocks, consider stepping in.

And most importantly, our sincere condolences to all whose family, friends, or lives have been affected by this terrible crisis.

Richard L. Peterson M.D.

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