What to do during a financial panic

The recent market gyrations have largely resulted from fears that the economy (either the global economy in general or the US economy in particular) is poised to drop into another recession similar to the most recent recession of 2008-2009. The memory of the market plunge that accompanied that recession is still fresh in investors' minds, and many are fearful of returns to the lows of early 2009.

There have been many articles written and video interviews broadcast about the differences between today's situation and 2008. We believe that an important distinction that should help investors understand why 2011 is not 2008 is the distinction between what we might call a "financial panic" and what we might call an "economic panic."

We explained the distinction at least as far back as December, 2008, when in this blog post we explained that the recession of 2008 was very different from typical recessions. In a typical recession, "companies have been over-optimistic, built up their inventories, hired too many people, and then were caught flat-footed when the economy suddenly slowed." In contrast, the recession of 2008 was not caused by anything that companies had done: it was caused by a panic in the financial sector caused by the implosion on Wall Street, which then caused companies to slam on their own brakes. Companies hastily canceled orders for more goods to sell, trimming their inventories and going into a sort of "state of shock" in which all expansionary activity was shut down until the panic subsided. In other words, a financial panic led to an economic panic.

Here in 2011, we are again not faced with the sort of behavior that typically precedes a recession: companies have not been over-optimistic, they have not built up excessive inventories, and they most certainly have not been hiring too many people in anticipation of massive increased demand.

However, in the past week we have experienced something of a mini-panic, in which markets around the world plunged in response to the S&P downgrade of the US credit rating and in response to fears of the loss of stable value in funds invested in European banks. The plunge was steep and violent and certainly characterized by panic selling, with severe volatility -- wild swings from one minute to the next -- and heavy volume. It reminded some observers less of 2008 than of 1987.

The question of the hour is whether this financial panic will result in another economic panic, as companies slam on the brakes and gape in slack-jawed amazement at the chaos in the markets. So far, we believe there are some encouraging signs that the economy may avoid catching the financial sector's panic this time around.

For one thing, the damaging mark-to-market accounting rule that was so critical to the previous implosion on Wall Street, by creating a vicious cycle or "feedback loop" which we described in numerous previous posts in 2008 and 2009 such as this one, this one or this one, has been put to rest. In fact, the end of that terrible accounting regulation during the first half of March 2009 initiated the beginning of the market and economic recovery.

For another thing, economic data, including real-time or very close to real-time data, shows that the economy continues to expand slowly, as explained in this video by respected economist Brian Wesbury, entitled "This is not 2008."

Finally, we believe that those parts of the economy where the government is less intrusive, real growth and innovation are still taking place -- especially in the area of networking communications, what we call "the Unstoppable Wave" (see for example this previous post). Evidence of the importance of this area of innovation and technology was reaffirmed today by Google's dramatic deal to acquire Motorola Mobility Holdings for $12.5 billion in cash.*

All of this, we believe, translates for investors into advice that we have reiterated before. First, don't panic. It has often been said that investors tend to damage their long-term returns in anticipation of economic calamity than in actual economic calamities themselves.

Second, swear off the advice of those who pretend they can predict what the economy or the market is going to do next -- we have explained before that this is a "persistent delusion" that has led many investors to ruin.

And finally, we believe that the best course of action for long-term investors is to commit their investment capital not to "the market" but to well-run businesses positioned in front of fertile fields for future growth. We believe that this is always good advice -- in fact, our entire investment discipline has always been based upon this conviction, and it has served us well through not just the 2008-2009 panics but previous recessions, going back in fact to the one-day panic of 1987. We believe it is just as applicable -- in fact, maybe even more applicable -- today as it has ever been.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Google (GOOG) or Motorola (MOT).