ALL BUSINESS:Investors Driven by Emotion

Tue Jan 15, 2008 4:22 PM EST

NEW YORK — "Get a neck brace," is what Ed Yardeni is telling his investment clients now. The market strategist says when shareholders get emotional, they tend to take stocks on wild rides.

That's just what has been playing out on Wall Street in recent days. Even the tiniest bit of news that investors think points to more economic weakness can send share prices plunging in a moment's notice.

Case in point: AT&T's shares tumbled immediately after its CEO mentioned "soften" and "consumer" in the same sentence, even though he made no changes to the company's earnings outlook. The market also slumped after Goldman Sachs forecast that the economy is heading into a recession, despite its view that an economic pullback could be short and mild.

Investors aren't looking at the incoming data objectively anymore. Recession worries are dominating their thinking, and they've taken to hunting for news — or sometimes just words — that can fit their gloomy view.

That's why this year has mostly started off on a sour note. The Standard & Poor's 500 index's 4.59 percent decline during the first eight trading days was the worst start for a year since 1982. The Dow Jones industrial average fell nearly 5 percent from Jan. 2 through Jan. 11, its biggest decline in that period since 1991. After a rally in stocks on Monday, Wall Street continued to pile on the losses in trading Tuesday.

There are reasons for investors to be worried. Falling housing prices have made it harder for homeowners to borrow against their properties, which no doubt is playing a role in the softness of consumer spending. And that's spooking corporate America, with many companies already protectively holding back on hiring.

At the same time, increasing mortgage defaults rates have caused lenders everywhere to tighten their borrowing standards, for businesses and consumers. Citigroup chief U.S. equity strategist Tobias Levkovich thinks Federal Reserve's February loan officers' survey could show banks tightening commercial and industrial loan growth by a net 30 percent since November.

Should such conditions result in a recession — which we won't know is happening until well after it has begun — it wouldn't bode well for stocks at least in the near term. Recessions on average last 216 days, or just over 7 months, and stocks post an average 8.64 percent decline during the first half of the pullback, according to Citigroup data dating back to 1953.

Some investors seem intent on making such ugly prospects a reality, as has been evident by their overreaction to some news.

"Investors are twitching," said Yardeni, who runs his own investment firm. "They are making extremely emotional decisions, which means every bit of news is amplified."

Just look at AT&T's stock selloff on Jan. 8. CEO Randall Stephenson blamed a weakening economy for an increase in the number of its landline and high-speed Internet customers not paying their bills, which has led the telecom company to disconnect their service.

"We're really experiencing some softness on the consumer side of the house from the economy," Stephenson said at an investment conference, according to a transcript provided by Thomson Financial.

He didn't give more detail than that, and the company declined to quantify the number of subscribers affected. There was no change in the company's earnings guidance, and analysts said the comments simply reiterated what Stephenson had said a month ago.

But shareholders were nonetheless unnerved, and bolted from the stock. Within minutes of his comments, AT&T shares sank 3.5 percent. By the end of the day, they lost 4.6 percent.

A day after that, Goldman Sachs' economists issued a report saying they believed there was a 66 percent chance that the economy would slip into a recession. That was higher than its previous recession estimates of 40 percent to 45 percent.

Many investors took that as a sign to sell, ignoring the guts of the report that told a more upbeat story. "The recession is likely to last about two to three quarters and show be relatively mild by historical standards, with a cumulative decline in real GDP" of about half a percentage point, it said in its report.

Market participants also are choosing to largely downplay any good news. For instance, there was a muted reaction to Federal Reserve Chairman Ben Bernanke's pledge to slash interest rates as needed to prevent housing and credit problems from plunging the country into a recession.

Investor sentiment is suffering because of recession worries. The weekly survey by the American Association of Individual Investors found that nearly 59 percent of its respondents were bearish, the most since 1990, according to Bespoke Investment Group.

At first glance, that sounds dismal for stocks. When the AAII survey in the past has gone bearish above 55 percent, however, the S&P 500 has been higher one year later, Bespoke said.

While the first half of a recession can punish stocks, the second half tends to reward investors. During the nine recessions dating back to 1953, S&P 500 stocks have gained 13.17 percent on average in the latter half of a recession, according to Citigroup's Levkovich.

Investors might want to reconsider fleeing from stocks. Holding tight could be a daring move in these uncertain times, but one that has the potential to pay off.

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Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org