I have been trying to understand the effects of the S&P downgrade of the US Treasury Debt, for the first time in several generations (it goes back before Pearl Harbor, at the very latest) from triple A to AA+ status. A lot of the commentators on the move insult S & P and downgrade its intelligence and wisdom in so doing, and say the move is of no importance whatsoever [1]. Others reflect, sensibly, that the downgrade of the US debt relates to the fact that America seems to have no handle on its spending and that politics is trumping statesmanship, even if they then go into gold-bug mode in suggesting the (dubious and risky) investment of tying one’s assets to the volatile markets for gold and silver [2]. Nonetheless, even though most people agree that there are not likely to be any immediate or practical consequences of the downgrade, immediately after the announcement stocks tanked by over 600 points on the Dow Jones Industrial Average, having its biggest one-day drop in almost three years [3]. Why is this so?

Abraham Lincoln said some one hundred and fifty years ago that in a democracy, the sentiment of the people is everything. In few places is that true more than in stock markets. We would like to believe that stock trading and investing are rational pursuits, but the evidence suggests that investors (and that includes people like you and me) are herd animals more than we are rational calculators. We buy and sell based on sentiment, on confidence, and sell when we panic or lack confidence. Now would be a time where we lack confidence. Our politicians may act as if everything is normal and that everything will always be fine, but a lot of people are not inclined at all to listen to that message. We are spooked, are concerned, are anxious, and every little event gets read as reinforcing that anxiety and providing reasons to be cautious or panicky. This is not an ideal position to be in by any means.

Part of the reason why this is so is because economics is more of a confidence game than it is a rational pursuit. Some people (wisely) see panic as a time to buy, knowing that even though a rising tide does not lift all boats (it tends not to raise the poorest of them), a sinking tide causes almost every boat to fall, meaning that corrections and panics tend not to recognize the difference between sound and unsound investments—all fall alike. This means that a savvy person can choose wisely and invest in the most sound places for more cheaply, and thus earn a higher return. Of course, it takes great moral courage to stand against the crowd. I know someone (who used to be a friend) who intellectually knew all of thus but tended to get caught up in crowds—he invested in the tech bubble, in the property bubble, now he’s probably in a gold bubble. The man was a walking example of what not to do. Whatever he did, he was doing following the crowd, meaning you had warning not to be found in that crowd when the bottom fell out.

Why is it that confidence is failing right now? Could it be because our actions seem (and are) unsustainable, and people fear that the music is about to stop in our game of musical chairs? Is it because we have a deep gnawing concern that we have been engaging in short-term moves and that, long-term, things cannot continue to go on as they have? This is reasonable—to some extent all of us (myself most definitely included) have made plans that proved to be way too optimistic given the grim realities of the situation, with awful consequences. But we only make those consequences worse when we panic. So long as we keep a sound head and can act rationally, we can take advantage of the fear and greed of others to live wisely and successfully. This is far harder than it sounds, but it’s better than playing the con game that everyone else is a sucker for.

[1] http://nymag.com/daily/intel/2011/04/sp_downgrade_what_does_it_mean.html

[2] http://wealthcycles.com/blog/2011/08/05/what-does-the-sp-downgrade-of-the-united-states-mean

[3] http://www.msnbc.msn.com/id/44054114/ns/business-stocks_and_economy/