What Should an Investor Do in Times of Panic?

Is "panic" too strong of a word to describe the markets in recent days? I don't think so. Consider a couple of examples outside of the investment banking space:

1) Constellation Energy (CEG)

My old utility company when I grew up in Baltimore, Constellation is the parent of Baltimore Gas & Electric. CEG gets 20% of its earnings from energy trading and had contracts with Lehman Brothers (LEH). Although CEG's net exposure to Lehman's bankruptcy was immaterial, investors panicked and sent the stock down from $60 last week to as low as $13 on Tuesday. Yesterday Warren Buffett's 88% owned MidAmerican Energy agreed to buy CEG for $26.50 in cash, or about 75% of the company's book value, in a deal that alleviates counterparty concerns over CEG's liquidity.



2) State Street (STT)

State Street fetched $68 before 10:00 yesterday morning and hit $29 shortly after 1:00pm. State Street is listed as a large holder of all the troubled financial stocks, which worried people, but STT is a custodian for its clients and index funds and does not own the vast majority of the stocks in question. The company simply acts as a custodian and collect fees for doing so. STT issued a press release yesterday afternoon trying to clear things up and assured investors their money market funds had not dropped below $1 in NAV.


There is no doubt in my mind that we are simply in the midst of a worldwide financial panic. The UK just restricted all short selling in financial stocks until the dust settles. Fear and mostly unsubstantiated rumors are driving price action right now.

So what should an investor do in this environment? It might surprise you, but I have been making very few moves during all of this craziness. Trading when fear, panic, and rumors have taken over doesn't make much sense because prices are not based on reality but rather perception. Lack of confidence and uncertainty about what is true and what is not is a deadly combination for financial markets and many firms. It doesn't matter if Morgan Stanley (MS) is not in trouble. If clients think they might not be, they will pull their money and set off a "run on the bank" scenario. That very situation will likely forced them to sell the company in the heart of the panic, regardless of what the reality is.

As long as you know and understand what you own and have done adequate fundamental analysis, I would suggest standing pat and waiting for things to settle down. Like LTCM, the Asian financial crisis and every other financial market panic, this one too will be over at some point. When that happens we can get back to good ol' fundamental investing. Fortunately, most of the people reading this blog, as well as myself and my clients, can wait for the storm to pass.

Full Disclosure: No positions in any of the companies mentioned at the time of writing.

Comments

[Kath H.:]

Unfortunately, prices of many stocks before the turmoil were really inflated and after the fall may take many years to return to previous levels, if they do at all. Assumptions for "adequate fundamental analysis" may be true one day and not the next. Or information one day may turn out to be essentially bogus, i.e. mortgage security ratings.

2008 Sep 19 08:32 AM

[css1971:]

What should an investor do?

Well that is obvious. Sell all our stocks, shares, gold and put the money safe in a bank account.

Course, there's that nagging problem that the banks won't lend money to each other... Gotta wonder what they know that I don't.

2008 Sep 19 08:45 AM

[captainccs:]

>>>Trading when fear, panic, and rumors have taken over doesn't make much sense because prices are not based on reality but rather perception.


Prices are always based on perception! On perceived value which may or may not turn out to be accurate. If you find a fellow who is willing to buy the stock for more than you paid for it, you win. If you can't find such a fellow and insist on selling, you lose.

Markets are based on exchange value only.

2008 Sep 19 08:48 AM

[User 265613:]

It may be of little comfort to realize that true business model fundamentals will be accurately reflected in stock prices for the vast majority of speculators and even investors with limited time horizons.

Long term investors who are looking to own "a share of a business" as opposed to "trading a stock" will hopefully have used the short term volaitlity to buy good businesses or add to their positions at a significant discount...

2008 Sep 19 10:08 AM

[Kelly Liebe...:]

When everyone keeps saying don't panic.. you need to wake up and TAKE ACTION!!!

This is bad news. I am not saying panic, I am just saying get your plan together immediately. We are headed for some nasty times ahead and nobody wants you to panic...because it will make things worse for them...get it?

2008 Sep 20 01:17 PM