by John Coates
What is it about October, anyway? Why is it always the scariest month for stocks? Almost every crash in the history books, at least those occurring in the US and UK, has taken place in the autumn, and most of those in October. The Panic of 1907, the Crash of 1929, Black Monday of 1987, the Crash of 1997 (related to the Asian Financial Crisis), the crashes of both 2007 and 2008 (related to the Credit Crisis) – all took place in October. It was thought in the nineteenth century and the early twentieth that crashes occurred in the autumn because farmers, needing cash for the harvest, withdrew their money from banks, causing bank runs and stock crashes. Perhaps that pattern lingers in our collective unconscious. But I will throw out another possibility. In many animals testosterone levels fluctuate over the course of the year, and in humans these levels rise until the autumn, and then fall until the spring. This autumnal drop in testosterone can lead animals into a condition called ‘irritable male syndrome’, in which they become moody, withdrawn and depressed. So maybe, just maybe, in the autumn traders’ animal spirits give up the ghost and risk-taking dims, taking stock markets down. While thinking along these lines, I might point out another oddity in the stock markets, and that is their observed tendency to outperform on sunny days and underperform between the autumn equinox and the winter solstice, an effect some have attributed to Seasonal Affective Disorder. Perhaps this too can be traced back to testosterone levels, for these increase with sunshine, and decline during autumn and winter months. Food for thought.
Next morning, as traders straggle back to work, many of them hungover, the market feels different. It is as if the accumulation of bad news, each piece on its own dismissible, has reached a tipping point. Stocks start the day in an ugly mood, Treasuries are in demand once again, and mortgages look wobbly. Shen goes over the squawk to give some colour on the news, and states the bank’s view that the housing market is in bad shape, but exports and manufacturing are holding up, so he does not expect too much damage to GDP. Martin follows Shen, but says he expects Treasuries to keep rallying, as the credit problems are only just starting. A nervous tension ruffles the floor. Traders are on edge, vigilant, sensitised to bad news.
And then it comes. Shortly after Martin’s commentary, two more announcements scroll across the screens. Traders and salespeople freeze as they read the news. Analysts at Morgan Stanley and Credit Suisse have also downgraded Citibank, and confirm the extent of the damage it has suffered. It is at this moment, all along Wall Street, that the penny drops. The US housing market is falling off a cliff, and is taking the banking system with it. No one on the floor, not even the most pessimistic of bears, anticipated anything like this. A momentary beat … then a roaring, desperate bedlam. Shen tries to comment over the squawk box, but is drowned out by salespeople from around the world shrieking for bids on mortgage-backed bonds, on corporate bonds, on anything with credit risk; others plead with Martin and Gwen for offers on Treasuries, in large size. Martin, his vagal brake still firmly engaged, pauses before quoting any prices, and watches as the mortgage market drops like a knife while the ten-year Treasury rallies half a point. Once he has a fix on prices Martin, like a skilled air-traffic controller, rapidly deals with a long line of waiting clients. As volatility rises, Martin and Gwen take centre stage as two of the only money-making traders on the floor.
Scott, on the other hand, stares at his screen, stunned. He is long sub-prime mortgage bonds, and they have just dropped $2, without any trading on the way down. He has just lost $6 million, and that on top of the $12 million he has bled over the past week. Deep in his brain, ancient circuits register the anomaly and the fact that it is a nasty one. From this point on, Scott’s body and brain begin to undergo far-reaching changes as a vast network of electrical and chemical circuitry switches on. For his amygdala, the emotional centre of the brain, has tagged this event as particularly dangerous, and has triggered the initial phase of what is called the ‘stress response’.
FIGHT-OR-FLIGHT ON THE TRADING FLOOR
The stress response is a rapid switch in body and brain away from everyday functions to a state of emergency. It evolved to deal with imminent physical threats, such as an accidental encounter with a mountain lion while foraging in the woods. In preparation for an exceptional muscular effort, be it fighting for our life or sprinting to safety, our body marshals all the glucose and oxygen it can, while shutting down long-term and metabolically expensive functions of the body. The stress response is an overwhelming experience, and over the long sweep of evolutionary time it has proved essential in keeping us alive. However while the stress response is useful when we are faced by a mountain lion, it can prove largely counterproductive when seated in the workplace. Indeed, workplace stress provides a vivid illustration of how our body can have a plan of its own for handling a crisis, one over which our conscious minds have little control.
The stress response unfolds in several stages: two fast ones, employing electrical impulses, and two slow ones, employing hormones. First, the amygdala must register the danger and pass on a warning via electrical signals to other parts of the brain, a rapid process taking place in a matter of milliseconds. Second, electrical signals sent from the amygdala via the brain stem to visceral organs such as the heart and lungs increase our heart rate, blood pressure and breathing. These signals begin to have their effects in less than a second, although their full effects can take a little longer. The initial electrical responses in body and brain are thus lightning fast, and when successful carry us clear of danger. But they are metabolically draining, and burn out quickly without more fuel. This fuel is provided by slower hormonal responses, such as adrenalin, which works its effects over the course of seconds and minutes. These early stages of the stress response constitute the ‘fight-or-flight’ response. This response, as we have seen, is initiated by any situation requiring a quick mobilisation of energy and attention. The hungry wolf chasing an elk, and the terrified elk running for its life, experience much the same fight-or-flight response. For that matter, so do Martin and Scott, even though one is in control and the other is not. In that respect Martin and Scott are not unlike wolf and elk, predator and prey.
Martin’s and Scott’s physiologies differ, however, in the final stage of the stress response. If a crisis lasts longer than fight-or-flight, then the shell of the adrenal glands, called the adrenal cortex (cortex means outer layer), secretes ever increasing amounts of cortisol. This hormone, the big gun of the stress response, brought into action to support us in a more sustained effort, takes effect over the course of minutes to hours, even days. Cortisol has powerful effects on our brain, and our health, and while Martin experiences moderate increases in this hormone and benefits from its invigorating effects, Scott comes to suffer ever higher levels, and these impair his judgement.
Let us watch each of these stages of the stress response unfold as Scott reacts to his money-losing position. First, he needs to become aware of the danger facing him by processing the information pouring in through his eyes and ears. One of the first brain regions to help him do so is called the thalamus (see fig. 10), found roughly at the cross-section of lines projected inwards from his eyes and ears. The role of the thalamus is to format sights and sounds as they enter the brain, so that they can be interpreted, just as data must be formatted before a computer can read it. Importantly, the formatting done by the thalamus is quick and dirty, producing what looks like a blurry, half-developed picture or what sounds like unarticulated gibberish. The thalamus then sends a rough image, in the case of a visual cue, up to the sensory cortex, where it is developed further, so that the image comes into focus and can be analysed rationally. However, at the same time as the thalamus is doing this it also passes a rough image to the amygdala, where it is assessed in a quick and tentative way for emotional significance – Is this an image of something I like? Is this something I should be scared of? Should I be happy, sad, scared or angry?
Why would we want to assess the emotional significance of a thalamic image we
can barely make out? Because it is fast. As we have seen, our brain faces an inevitable trade-off between speed and accuracy, and in an emergency we choose the speed of pre-conscious processing. If we spot a dark moving object while on a hike through the woods, it could be a shadow formed by swaying leaves, or it could be a bear. Our rational brain will, with time, establish which of these it is, but this takes precious seconds, and if it is a bear that extra time may mean the difference between a narrow escape and none at all. Thus our brains have evolved what Joe LeDoux has called the high and low roads for information-processing: the thalamus–cortex circuit being the slow but accurate high road; the thalamus–amygdala circuit, which cannot distinguish between a shadow and a bear, the fast, low road. With the aid of the low road we react first and calm down later, feeling slightly foolish, in the case of a false alarm, that swaying leaves startled us so much.
So when the shocking analysts’ reports flash up on the news screens, Scott’s first amazement is processed by his amygdala, which mutely, stupidly registers: this is bad. His amygdala then passes on the bad news to the locus ceruleus and the brain stem. The brain stem, roused by the amygdala’s clarion call, now accelerates a fight-or-flight response that had already been activated, albeit at low levels, before the housing number was released. Let us recap what happens and add more detail.
Electrical impulses race down Scott’s vagus nerve and down nerves in his spinal cord, branch out into his body and stimulate his respiratory and cardiovascular systems. His heart rate speeds up, and with it his blood pressure, pumping the extra blood needed to fuel a fight to the finish or a dash through the forest. The surge in blood flow is selectively targeted, with arteries to the skeletal muscles dilating, forcing more blood to major muscle groups in the thighs and arms. At the same time arterioles – tiny arteries – in the skin constrict, to reduce bleeding if injured, giving Scott’s skin a clammy feel and his face a pallor. Blood vessels in the stomach also constrict, since digestion is not currently needed, giving him the butterflies. Breathing accelerates as the lungs try to provide enough oxygen for the increased blood flow. The skin starts to sweat, cooling Scott’s body even before the expected physical exertion begins; as do his palms and the soles of his feet, perhaps a throwback to an earlier evolutionary period when escape involved scurrying up vines or branches. Pupils dilate to take in extra light. And salivation stops, to conserve water, giving Scott a dry mouth. In cases of extreme fright the erector pili muscles at the base of body hairs can contract, causing hair to stand on end, or, where hair no longer exists, causing goosebumps.
Many of these physiological changes occur so quickly that Scott’s consciousness is left behind, playing little part in his body’s first reaction. After a moment or so his rational brain catches up, and unfortunately it confirms the amygdala’s fast and dirty assessment – he is indeed in a pretty bad situation. At about the same time, the hormonal phase of the fight-or-flight response has started with the release of adrenalin. As adrenalin starts to course through his blood vessels it taps into the energy stores needed to support his fight-or-flight response, mostly by breaking down glycogen (the molecule used to store sugars) from the liver and turning it into glucose. The adrenalin also increases blood coagulation, so that in the event of injury his blood will clot quickly. As a further safeguard against injury, the immune system floods natural killer cells into the bloodstream in order to battle any resulting infection.
Scott needs to think clearly about his position and the market, but oddly, inappropriately, his body has atavistically prepared him to fight with or run away from a bear. The stress response is prehistorically hamfisted in this regard. It does not distinguish very clearly between physical, psychological and social threats, and it triggers much the same bodily response to each one. In this way the stress response, so valuable in the woods, can prove archaic and dysfunctional when displaced onto the trading floor, or for that matter any workplace. We need to think, not run.
So far, Scott’s stress response, although slightly uncomfortable, has not seriously impaired his ability to deal with his loss. Dropping $18 million at year end is definitely bad news, but Scott has lost a lot of money before and made it back. Years of trading have tempered him into a durable risk-taker, and at moments like this he proves he can resist the ancient and insistent pressures exerted by the stress response and trade effectively.
A WORSE DAY ON THE MORTGAGE DESK
Risk managers now mill about the arb desk and look over Scott’s shoulder. In the background, from all across the floor come the angry sounds of thwarted plans – strangulated screams, bellowed obscenities, smashed phones. Logan has been particularly hard hit, and is in mid-tantrum. Stefan, the head of the arb desk, dealing with his own loss on derivatives, totalling almost $60 million, calls the group together for a hasty conclave. Do they close out their positions and limit their losses at year end? Or add to them, hoping to make back all they have lost, maybe more? The traders, in half-finished, telegraphic sentences, bounce opinions back and forth, agreeing the move is overdone. Hedge funds, they reason, have been shorting mortgages and will want to cover after a move of this magnitude; and besides, with the housing market collapsing the Fed will surely continue to lower interest rates, a policy that normally causes mortgages, stocks and other credit-sensitive markets to rally. Expecting a bounce any time now, the traders decide to add to their positions. The risk managers look concerned, remembering similar arguments made during the Asian Financial Crisis and the Russian Default, but agree, based on the desk’s track record this year, to let the traders increase the size of their trades. Once again the risk managers are in an impossible situation – if they refuse, and the market goes up, they will get blamed for lost profits.
Scott rolls his chair back to his desk and pulls up a real-time charting tool on his computer. These charts, it is claimed, help traders find patterns in the bewildering zigzags of securities’ prices. In particular, charts supposedly show what are called ‘support levels’ in the markets – mortgages, stocks, currencies, whatever – price levels at which investors are expected to step in and buy, driving prices back up. The charts, as many have pointed out and as Scott fully knows, are drawn and sold by people hailing from dubious intellectual backgrounds: the support levels are supposedly based on Fibonacci numbers, a perfectly respectable mathematical progression found in natural phenomena such as the spiral pattern of a seashell, but these sequences have become, disconcertingly, a staple of pop culture, turning up in novels such as The DaVinci Code, where they provide a frisson of hidden patterns. These charts border on number mysticism, yet if enough people believe them they become self-fulfilling. Scott, aware of how many traders follow the charts, puts in a bid to buy another $200 million of the ABX mortgage index at a price of 34.00, the next major support level, which would take his total position up to $500 million. As the mortgage market grinds its way down, bringing his daily loss up to $9 million, Scott gets filled on his buy order. Glancing at the other arb traders, he guesses they too have now added to their positions.
The stock market quickly dips another half a per cent, and mortgages drop in sympathy, surprising the guys with a grim moment, but then stabilise and creep back up to the levels at which Scott has just bought. And now Scott, together with the arb desk, and behind them the thousand-strong trading floor, and behind it the hundreds of similar trading floors around the world, waits for that reassuring elevator-tug as the markets bounce. And for a while they do, stocks, mortgages, corporates, tentatively building up confidence, gathering buyers, the incipient rally picking up steam after a rumour spreads that the Fed will make an announcement later that day, no doubt stating its resolve to support the market. Mortgages rally 2 per cent, reducing Scott’s loss. Legs twitching, egging the market on, Scott feels the old magic returning, and senses relief along the arb desk. If this market keeps rallying, he could actually make money today.
But after an hour of slogging upward, cent by laborious cent, the rally look
s unconvincing, tentative, and fails to build on itself. Other rumours begin clouding the picture, about mortgage originators having liquidity problems, hedge fund losses, banks taking massive write-offs on their bad loans, the British banking system collapsing, and the rally stalls. Soon the selling re-emerges – a mutual fund in the Midwest, a hedge fund in Zurich, the night desk at the Bank of Japan, the squawk box crackling with salespeople looking for bids on mortgage and corporate bonds. Confidence falters and the market fails, dropping slowly, insistently, then building up speed, slicing back through the 34 support level, through 33.75, plummeting in the next 45 minutes to 33.05. Scott was quick to sense the change, and has been trying desperately to sell out his position, but bids just disappear before he can hit them, and within half an hour his loss has grown to maybe $16 million, almost a third of his year. Even then he can’t be certain of his P&L, mortgage prices jumping around so much no one can be sure where they are. Nor for that matter of his true position: he has traded so fast and frantically he cannot be certain all his trades have been entered, or entered correctly. And now, in a daze, a panic, rancid sweat seeping from his pores, Scott watches spellbound as the bottom falls out of the market and it is sucked into a death spiral, the occasional price flickering on the way down – 32.50, 32.15, 32.27, 31.90, 31.35 – a wretched din from the trading floor heard as in a dream, and by mid-afternoon, as prices settle, the news tape reports the ABX down a record 12 per cent. The back office confirms Scott’s position and he is still long most of his bonds, about $415 million. Prices and positions in his risk-management system stabilise, and reluctantly, fearfully, he looks at the P&L number posted in the bottom right-hand corner of his computer screen, gasping as he sees the loss of $24 million, almost all the money he has made in the past six months. The news goes off like a depth charge in his brain, breathing accelerates, blood pressure rockets, and his bowels liquefy.