The Delusions of Crowds: Stock Markets

 Humans spent most of their history evolving to maximize the success of the small bands of hunter-gatherers in which they lived.  Of necessity, numerous pro-social attributes designed to facilitate cooperation and sharing would develop.  One would be the ease with which we can be influenced by the actions and words of others in our group.  Peer pressure can be exceedingly strong, prompting individuals to take actions in a group that they would never participate in as an isolated individual.  Edward Chancellor discusses this “madness of crowds” in an economic context for an article in the New York Review of Books titled Waiting to Deflate. 

“Imitative behavior was a successful adaptation for early Homo sapiens—if one of our ancestors was seen fleeing from some unspecified danger, it probably made sense to run, too, without asking many questions. But in the complex modern world, imitation can amplify maladaptive behavior, allowing delusional beliefs to take hold. This problem is exacerbated by another innate tendency: our susceptibility to engaging stories, especially ones that transport people from their immediate surroundings and isolate them from the facts of the real world.” 

The first serious exposition on the folly of following the actions of others in the world of speculative finance appeared in 1841 by Charles Mackay: Extraordinary Popular Delusions and the Madness of Crowds. 

“Mackay’s book…covers an eccentric miscellany of popular delusions, from the witch mania of the sixteenth and seventeenth centuries to alchemists, magnetizers, slow poisoners, and the ‘influence of politics and religion on the hair and beard’.”

“The book’s opening three chapters—which describe the Tulip Mania of 1636–1637, the ‘money mania’ of John Law’s Mississippi Scheme of 1719–1720, and the South Sea Bubble (also of 1720)—comprise the first popular account of speculative manias.”

Chancellor reviews the more recent work of William Bernstein presented in his book The Delusions of Crowds: Why People Go Mad in Groups.

“Bernstein, a trained neurologist and the author of several investment books, is particularly well suited to the task of updating Mackay, and his Delusions of Crowds is a worthy supplement to the original. Yet more accurate historical accounts of speculative manias and advances in the psychology of decision-making have failed to produce any noticeable improvement in financial behavior. On the contrary, over the past quarter-century, we have witnessed a succession of speculative bubbles, from dot-com stocks to the current craze for new technologies such as electric vehicles and cryptocurrencies.”

There is a hint of something called “the wisdom of crowds,” but the term is misused because it actually applies to a collection of individuals acting independently.  A crowd is by definition an assembly of interacting people.

“Errors appear when individuals become overly influenced by what others think. ‘The more a group interacts,’ Bernstein writes,

the more it behaves like a real crowd, and the less accurate its assessments become…. As put most succinctly by Friedrich Nietzsche, ‘Madness is rare in the individual—but with groups, parties, peoples, and ages it is the rule.’ Mackay also recognized this; perhaps the most famous line in Extraordinary Popular Delusions is ‘Men, it is said, think in herds; it will be seen that they go mad in herds, while they only recover their senses more slowly, and one by one’.” 

For a crowd to develop delusions it is necessary that communication between participants be available.  The greater the ease of communication, the more contagious a notion can become. 

“…manias of financial speculation have frequently coincided with advances in communications technology. The earliest stock market boom occurred in London’s Exchange Alley in the 1690s, at a time when newspapers were deregulated and lists of share prices were first published in trade publications. The advent of steam railways and the electric telegraph in the nineteenth century provided both objects of speculation and means for more rapidly spreading speculative hype. The same was true of radio and telephony in the 1920s.”

“Likewise, the arrival of the Internet in the 1990s served as both the medium of speculation and its object.”

History tells us that financial bubbles are not spontaneous eruptions, they require promoters and sponsors who will benefit in some way.  And for a bubble to see spectacular growth, the inducement of new participants to financial speculation is required.

“Governments frequently have a leading role. The French and British governments encouraged bubbles in the Mississippi and South Sea Companies because they wanted public creditors to swap their debt holdings for overpriced stock in these companies.”

“Modern politicians often view the level of the stock market as a measure of their personal success: during his term in office, President Trump tweeted new highs on Wall Street and browbeat the Federal Reserve to loosen monetary policy in order to send shares even higher.”

“The financial media, whose advertising incomes rise and fall with the markets, encourage trend-following behavior. Roger Ailes joined the business channel CNBC in 1993, just before the dot-com boom took off. According to Bernstein, ‘Ailes taught his anchors and production staff to treat finance as a spectator sport.’ Skeptics dubbed the channel ‘Bubblevision’ for its relentlessly upbeat presentation of market news, while Ailes’s protégé Maria Bartiromo became known on Wall Street as the ‘Money Honey’.” 

The term “speculation” implies a willingness to accept risk to attain financial gain.  It differs from investment in that the intention is to strive for short-term gains rather than long-term returns: shares are bought on the assumption that they can be resold at a profit.  The motive for purchasing shares need only be because they are currently going up in value, not because of intrinsic worth.  If this is the dynamic in play, them stock markets in a bubble phase have the trappings of Ponzi or pyramid schemes: early participants become wealthy at the expense of later participants. 

In all cases, easy credit is the fuel that feeds the speculative flames.

“Credit enables investors to buy assets with debt; easy money boosts the demand for speculative assets, driving up prices and increasing potential gains for those who can cash out in time. Falling interest rates also encourage investors to take greater risks, pursuing capital gains to replace lost income from their debtors. The greatest speculative manias have all been fueled by easy money, from the Mississippi Bubble down to the recent US housing bubble, which took off after the Federal Reserve lowered interest rates in response to the dot-com crash.  As Bernstein writes, ‘low interest rates are the fertile ground in which bubbles sprout’.”

Stock market behavior since the beginning of the Covid pandemic has been truly astonishing: indicative of madness and worthy of bubble designation.

“As global economic output contracted sharply in response to the Covid-19 pandemic, the financial markets took off. Over the course of 2020, the S&P 500 index rose by 16.3 percent. The share price of electric-car maker Tesla climbed nearly eightfold; the leading cryptocurrency, Bitcoin, priced at around $7,000 in January 2020, traded above $32,000 a year later and a few months after that rose above $63,000. Millions of brokerage accounts were opened in the United States, a record amount of money was raised by initial public offerings (IPOs), and American house prices soared to new highs, as did household wealth.”

“Last year the Federal Funds Rate was reduced to zero and the US central bank doubled the size of its securities holdings. As a result, the money supply surged, and US Treasury yields fell to an all-time low. Easy money has encouraged the use of leverage: earlier this year, a fund run by the Korean-born investor Bill Hwang lost billions of dollars; Hwang is believed to have leveraged his investments by as much as nine times. Retail investors have also been using debt to make purchases on the stock market. As in 1929, margin debt has reached an all-time high. A recent investor survey reveals that 40 percent of individual investors have borrowed to buy stocks (the figure rises to 80 percent for Generation Z investors).”

“Warren Buffett’s longtime business partner Charlie Munger has described the latest stock market frenzy as ‘the most dramatic thing that’s almost ever happened in the entire world history of finance.’ He was hardly exaggerating.” 

Chancellor compares the current situation to famous bubbles of the past.

“In the early eighteenth century, the South Sea bubble was marked by the appearance of nearly a hundred so-called bubble companies; these enterprises, according to a contemporary journal cited by Mackay, were ‘set on foot and promoted by crafty knaves, then pursued by multitudes of covetous fools, and at last appeared to be, in effect, what their vulgar appellation denoted them to be—bubbles and mere cheats’.”

“Similar words might be applied now to the promoters of special-purpose acquisition companies (SPACs), shell companies that are listed on stock markets and used to acquire unlisted companies, thereby providing a back door into markets without having to go through regulatory processes for initial public offerings. SPACs raised $93 billion in the first few months of this year.”

“The bubble companies of 1720 covered a miscellany of ventures—from a ‘company for the transmutation of fluid mercury or quicksilver’ to one for ‘emptying necessary houses [public toilets] throughout England’ and another, most famously, ‘for carrying an undertaking of great advantage, but nobody to know what it is’—and recent SPACs are scarcely more credible. They include several flying-taxi start-ups, a space-travel venture, and a ‘developer to augment humans to enhance productivity and safety.’ Cashing in on Tesla euphoria, many SPACs are makers of electric vehicles, sensors, and batteries. In place of the ‘crafty knaves’ of 1720, the SPAC ‘sponsors,’ as they are known, receive such a generous ‘promote,’ usually a 20 percent stake in the company at the IPO, that they stand to profit even when their deals lose money for outside investors.” 

To keep a bubble going, it is helpful to provide a mechanism for inducing new participants to join the game and garner what looks like easy money.  One should beware because easy investment options encourage new investors to put their meager wealth at play in a game best won by “crafty knaves.” 

“Alongside SPACs, we have witnessed the spectacular rise of the app-based broker Robinhood. Launched in 2013, Robinhood added 13 million new customers between January 2020 and March 2021. The recent surge in users has been ascribed to the fact that casinos and sports betting were closed during the pandemic shutdowns, and Robinhood’s mostly young clientele was flush with cash from stimulus checks.” 

“Robinhood has made the game of speculation easier to play and more addictive than ever. It enhances marketability in various ways: customers don’t have to meet a minimum account size, can conduct commission-free trades, and are able to trade in fractions of shares. The company hails from Silicon Valley and blends techniques devised by social networks to attract users’ attention with those of casino operators meant to keep people betting. New customers are offered a free stock upon joining; the app sends them emoji-filled notifications and erupts in confetti after a customer places an order; digits spin up and down like a slot machine when share price changes; and an alert is sent once a price rises by more than 5 percent. All these techniques are designed to draw customers back to the app.” 

As with many Silicon Valley products, free service to a user tells the user that he/she is the product being sold.

“Robinhood’s customers don’t pay transaction fees because the company earns money by selling information about their trades to financial firms, which are only too happy to take the other side of the bet.  As with Facebook and Twitter, Robinhood’s users are the product. If history is any guide, this won’t end well.”

One does not have conclusive proof of a bubble until the bubble actually bursts.  The rapid contraction can occur because of external events, or merely because the “crafty knaves” are sated with profits and quit the game.  We are in a perilous time: a perhaps unending pandemic, increasing job loss to automation, plunging birth rates, accelerating impacts of global warming—and the markets go sky high? 

Find a quiet dark place and think!

You can learn a little about a lot of things or you can learn a lot about a very few things. Guess which is the most fun.