The Florida Land Boom of the 1920s and the South Sea Company trading rights in the early 1700s are two examples of financial mania – untold growth and quick and easy gains. There are many others such as the famous Dutch tulip mania in the seventeenth century, John Law’s Mississippi scheme, and the bull market in the 1920s. No two instances are identical, but they all share some common characteristics. We do need to stress that even though these experiences all represent extremes, they are nevertheless indicative of the day-to-day market psychology. The principal difference between a mania and a more common emotional fluctuation is that the mania lasts much longer and goes to a far greater extreme.
The elements that make up a mania can be summarized as follows under two headings – “The Bubble Inflates” and “The Bubble Bursts”.
The Bubble Inflates
A believable concept offers a revolutionary and unlimited path to growth and riches.
A surplus of funds exists alongside a shortage of opportunities. This channels the attention of a sufficient number of people with money to trigger the immediate and attention-getting rise in price. These are the germs that spread the contagion.
The idea cannot be irrefutably disproved by the facts but is sufficiently complex that it is necessary for the average person to ask the opinions of others to justify its validity.
Once the mania gets underway, the idea has sufficient power and compelling belief to spread from a minority to the majority as the crowd seeks to imitate its leaders.
The price fluctuates from traditional levels of overvaluation to entirely new ground.
The new price levels are sanctioned by individuals considered by society to be leaders or experts, thereby giving the bubble an official imprimatur.
There is a fear of missing out. The flagship or centerpiece of the bubble is copied or cloned as new schemes and projects attempt to ride on the coattails of the original. They are readily embraced, especially by those who have not yet participated.
Lending practices by banks and other financial institutions deteriorate as loans are made indiscriminately. Collateral is valued at inflated and unsustainably high values. A vulnerable debt pyramid is a necessary catalyst for the bust when it eventually begins.
A cult figure emerges, symbolic of the bubble. In the Mississippi scheme, it was John Law himself; in the 1920s, famous stock operators such as Jesse Livermore. In the late 1960s, Bernie Cornfield symbolized the so-called mutual fund “gunslingers,” and more recently Michael Milken represented the late-1980s LBO craze.
The bubble lasts longer than the expectations of virtually everyone. Commentators who warned of trouble in 1928 were initially taken seriously but were way too early and were discredited in the early part of 1929.
An atmosphere of fast, easy gains almost invariably results in shady business practices and fraud being practiced by the perpetrators of the original scheme, for example, the insider scandals associated with the 1980s LBO mania.
At the height of the bubble, the possibility exists that even the most objective person can come up with a simple but eye-catching statistic proving that the madness is unsustainable. In our own time, we note that in the late 1980s, the value of the land encompassing the Emperor’s Palace in Tokyo was equivalent to the total value of all New York. Just before the Japanese stock market peak in 1990, price/earnings ratios reached historic proportions, not just by Western standards but by Japanese ones as well.
The Bubble Bursts
There is a rise in prices sufficient to encourage an influx of new supply. In the case of the stock market, new issues are offered to investors at an increasing rate. If viable companies cannot be found, money is raised for concepts. We saw this kind of activity in 1720 but it was just as relevant at the end of the new issues boom in 1968-1969. The scale may have been smaller, but the principles were identical. In effect, it is possible to lower investment standards because an increasingly gullible public is demanding new vehicles for instant wealth. A different example occurred in 1980 at the height of the silver boom. In this instance, increased supply took the form of ordinary people finding prices far too attractive as they rushed to sell the family silver to be melted down into bars that could then be sold at higher prices.
Another cause comes from a rise in the cost of interest, either as a result of the increasing demand for credit or from the curtailment of supply from an increasingly skeptical government or both.
Prices do not just fall, they collapse. The “concept” stocks are exposed for what they are – concepts. Collateral for loans evaporates overnight. Bankers not only are reluctant to expand credit for new ventures but also try to protect themselves by calling in existing loans. The result is a self-feeding downward price spiral as everyone heads for the exit at the same time.
Inevitably, fraud and other shady dealings are exposed. These sometimes represent a cornerstone of the debt pyramid, the removal of which is a primary cause of the price collapse. At other times, they are ancillary or contributing factors that adversely affect the general level of confidence.
The government or other quasi-government agencies occasionally intervene to try to shore up confidence. Such activity merely gives cooler heads the chance to unload before the real price decline sets in. We saw this in November 1929 when a group of major banks headed by J.P. Morgan attempted to support the market. Anticipating the bursting of his own bubble, John Law staged an elaborate parade in Paris but only kept the bubble afloat for a few days. In more recent times during lesser crises, we have grown accustomed to government jawboning. Such actions and words can only be aimed at the symptoms of the problem, since the problem itself has usually progressed beyond the point at which it can be corrected other than by a painful adjustment in prices.
Excerpted from “Investment Psychology Explained”
Related Article: When to Go Contrary