A very insightful report on how and why bubble's develop and burst |
By Eric Janszen
"A friend remarked to me last week, "You've been calling this stock market a mania since the middle of 1998. Do you still think it is?"
The question itself is a marker of a stage in the lifecycle of a financial mania. No two financial manias are alike, but were a mania a love relationship, it'd be a multi-year affair rather than a one-night stand.
This is not what we imagine from watching footage of the most famous mania ending, the crash of 1929, the first such collapse captured on film (and surely not the last). Grainy black-and-white documentaries leave the
impression that the market crashed on Black Monday and soup lines formed by Friday. In fact, the market took some three years to bottom out and many mini-rallies took place along the way to the depths of the 90% decline, dragging down many who escaped the first wave of destruction.
The 1920s bubble was only a few years in the making. Our bubble has had nearly six years to form. It cannot be expected to disappear like that glorious rainbow-colored orb your brother maliciously jabbed. No, wrong analogy. The word "bubble" does not convey the financial mania dynamic faithfully into the physical world. Some manias run for a short intense period like a fireworks show run amok, quickly burning out. Others develop in fits and starts, like a storm rising up in great waves, falling back, then rising still higher. The current bubble is of the latter type. The storm has been raging for years. And lately, the waves are getting pretty wild.
Every student of the markets knows psychology plays an important part in market dynamics, although no one knows exactly how. No tools for measuring sentiment or other elements of market psychology have statistically meaningful predictive powers. But at core, it's surprisingly simple. Humans mostly decide what to do by observing others they perceive as similar to themselves, comparing the observed behavior to their personal normative standard, and taking action that is an average of the two. Each individual has his or her own reference point for what is "normal" behavior but an individual will act in ways that are very far from their personal normative boundaries to a lesser or greater extent depending on, 1) the number of other people "like them" who are behaving like each other and, 2) the length of
time the group has been engaging in the behavior.
A financial mania, like any aberrant and self-destructive group activity, grows as new entrants and the passing of time legitimize the activity. Much
research demonstrates this dynamic of human behavior, including studies that followed the famous case of the woman who was stabbed to death over a period of hours on a crowded New York City street many years ago. The studies concluded that if you are attacked, you are far safer in the company of a single witness who is likely to judge the inappropriateness of the attacker's
behavior and take personal responsibility for your rescue. In a crowd, individuals take the inaction of others as a cue that inaction is the right course, leaving you to your unhappy fate. It is no revelation to apply this concept to group dynamics in financial manias, for as Charles MacKay observed way back in 1841's Extraordinary Popular Delusions And The Madness Of Crowds, "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."
The individuals with the strongest will or motivation to employ their personal standards in contradiction to the group's behavior naturally join in last. In the case of a financial mania, the most risk-averse members of society join in when intuition misinforms them that the risk is at its lowest, because so many people are involved and the mania has lasted so long. In fact, that's when the risk is at its highest. This is the so-called "widows and orphans" stage.
The friend whose remark launched this piece is a financial advisor in Boston. She works for a staid firm with many rich, elderly clients. She noted last week that she was beginning to get calls from her most conservative clients, asking why she had not recommended the purchase of Internet stocks, angry that they were missing out on the spectacular capital gains. These are men and women who lived through the crash of 1929. This development alarmed her. And well it should -- for it portends the final stage of this financial mania, the one that draws in the those who can least afford to lose, those too old to make their money back. They are also the final source of new money for the mania, indicating that the mania is about to run out of fuel.
What sets up a market crash is the anxiety that forms from cognitive dissonance. As the mania progresses, an ever-widening gap develops between each individual's reference point of normality and the extreme behavior of
the group. An unconscious desire to close the gap by any means intensifies over time. In the latter stages of a mania a number of influential figures in
the mania step up to address these anxieties with elaborate justifications,such as Irving Fisher's "scientific" analysis of the New Era economy that
"explained" the historically unprecedented stock prices in 1929 and, in our time, recent books such as DOW 36,000 and DOW 100,000. In spite of the analytical acrobatics, each mania participant's normative compass remains intact and the anxiety persists, leading to the desire for mania participants to "throw themselves from the precipice for fear of falling," in the words of
What causes each individual to jump is an unpredictable event that causes an epiphany. Imagine participants in the 1920s mania viewing a film in 1930 of themselves in a soup line. Still think they'd standing in line to buy stock with hard-earned money, or borrowed money? All this happens in the mind's eye during the epiphany. Unfortunately for each individual, the destruction of
the mania feeds on itself by the same process that caused the growth of the mania: observed behavior of other participants. Whereas before they were all
buying because they saw everyone else buying, now they are all selling because everyone else is selling.
In my last piece, I identified the four events that will most likely trigger the mania's end: credit squeeze, bankruptcy, fraud, and weakness in the real economy. Since then, three of these elements have developed. Long-term interest rates have risen 250 basis points, the SEC indicted Tokyo Joe for pushing stocks he owns, and home and SUV sales -- the bellwether consumer items of the mania -- have begun to fall significantly. So far no high-profile bankruptcy has developed, but all that is required to create an avalanche of bankruptcies is the failure of the Fed to quickly reflate the money supply after the next correction; if public and private
capital hides for more than a quarter or two, many unprofitable iTulip.com companies will not be able to raise new capital in the markets to pay the bills. As these companies fail, more capital will be frightened away from the market, causing more to fail, and so on.
The end of a mania is a sad event. So do not be impatient to see it end. For afterward, all that once seemed a community of warmth and lightness and fun
turns cold, dark and lonely."