Part A – Speculative Mania
Neil A Costa
One of the fundamental weaknesses of human beings is our desire to ‘get rich quick’. On the one hand, our head tells us to be cautious. We know that there are few genuine rewards to be gained in life without hard work. On the other hand, something inside us makes us want to chase the quick big bucks.
Wherever there is a desire to make ‘easy’ money, there are unscrupulous people who will relieve greedy people of their hard-earned money. Collectively, these people comprise the ‘temple of boom’!
One key to being able to survive and prosper is awareness. We are less likely to make crazy decisions based on greed or fear if we are aware of how human beings behave when influenced by crowd behaviour, and how this behaviour tends to be consistent over time. We are also less likely to become the victim of con artists if we have a basic awareness of the techniques they use to lure their victims.
The second key is discipline – the discipline to say “no”, or “no, not until I have researched this more thoroughly”.
Awareness and discipline are the keys to surviving and prospering as a trader or investor in the temple of boom.
The reason we use technical analysis (and fundamental analysis) is because history repeats. Human beings are today as much the victims of the emotions of greed and fear as they were centuries ago.
“But”, you say, “… it is different this time. We live in a technologically advanced age.” If you believe that it is different today, and that we are too sophisticated to become the victims of speculative manias, you would probably agree with the following quotation from Professor Irving Fisher, formerly of Yale University.
“We are living in an age of increasing prosperity and consequently increasing earning power of corporations and individuals. This is due in large measure to mass production and inventions such as the world never before has witnessed… This is a new and tremendously powerful factor… and one which never before existed.”
Professor Irving Fisher was an economist and stock market authority. He also stated, when asked if he thought the market was too high, that he thought the market had reached a permanent plateau of prosperity.
Sadly for Professor Fisher, his statement was made in 1929 – at the time of the market top and just prior to the crash. The Dow subsequently lost some 90 percent of its value as the market fell into its final bottom in 1932.
The experts thought it was different in 1932. It is different every time – unless one studies a chart and notes the parabolic curve and blow off top that occurs at the end.
As individuals, we tend to behave in an intelligent, controlled manner – at least most of the time. When we become members of a crowd, however, our behaviour can change quite considerably.
Human beings become members of a crowd and follow the crowd because:
- Being a member of a crowd gives them a feeling of security.
- Following a strong leader allows them to feel reassured.
- Doing what others do helps to combat a fear of uncertainty.
- They have felt secure being members of different groups all of their lives, and hence are conditioned to wanting to become a member of a group.
As members of a crowd, we tend to follow the crowd leader, and to trust the judgement of the crowd leader more than our own judgement. In the case of trading, the crowd leader becomes ‘price’. Members of crowds tend to respond only to very obvious changes (such as a market crash), and not slow, subtle changes, such as a bull market slowly making a topping pattern and turning downward. They also become more emotional and impulsive – which is not a desirable characteristic of a trader.
An understanding of crowd behaviour will help you to understand how traders become mesmerised by roaring bull markets, and how they fail to see the clear warning signs that the market is becoming dangerously overbought. Such an understanding can make you, and save you, a great deal of money!
An understanding of how individuals behave when they are a member of a crowd is very important for a trader, as there are times when a trader must do the exact opposite to what the crowd is doing. In trading, this understanding comes from studying the theory of contrary opinion.
To be a professional trader, you need to be able to analyse what ‘the crowd’ is doing at any one time, and be prepared to do the opposite should your trading system give you a signal to do so. At the very least, you should exercise the utmost care when you observe extreme crowd behaviour. The crowd’s collective judgment is correct in the middle of market moves. It is wrong at market tops and bottoms.
Anatomy of a Speculative Bubble
In a ‘normal’ liquid market, there is a balance between buyers and sellers. When there is an imbalance of buyers and sellers, market prices rise or fall. If the strength of the buyers outweighs that of the sellers, the market will rise. It will keep rising until the buying pressure has been exhausted. If the sellers are the stronger group, the market will fall.
Manias occur when the vast majority of traders want to buy at once. Crashes occur when the vast majority of traders want to sell at once.
Let us examine a few examples of human greed that drove markets to levels, which bore no resemblance to the fundamental value of the underlying commodity. These examples also illustrate why it is dangerous to assume that human beings behave in a rational manner when making trading or investment decisions.
From time to time, the effects of crowd behaviour can be observed in market action. An excellent example occurred in Holland in the 1600’s. Today it is often referred to as ‘Tulip Mania’.
Tulip Mania of the 1630s
The people of Holland became obsessed with tulips in the 1630s. Rare tulip varieties were discovered, propagated, and sold for higher and higher prices. At their peak, the owner of one Samper Augustus bulb was offered 12 acres of land in exchange for a single tulip bulb and another Tulipe Brasserie bulb was exchanged for a profitable brewery in France!
Eventually government intervention halted the mania, and prices crashed in 1637. Fortunes were lost in a matter of days.
Mackay, in his classic book Extraordinary Popular Delusions and the Madness of Crowds, first published in 1841, concluded that entire communities could be deluded in the pursuit of easy wealth.
We find whole communities suddenly fix their minds on one object, and go mad in its pursuit; … millions of people become simultaneously impressed with one delusion…
(Preface, Extraordinary Popular Delusions and the Madness of Crowds.)
Tulip mania is but one example of the greater fool theory in operation. Sane and intelligent people willingly pay ridiculous prices for something, in the hope that they will eventually be able to sell the commodity for a much higher price to an even bigger fool.
In reality, the chart of tulip bulb prices is a chart typical of a ‘bubble’, or ‘speculative mania’.
From a trader’s perspective, speculative bubbles have led to many people making a great deal of money, trading both on the upside and on the downside. Many inexperienced traders, however, have lost large sums of money, being lured into the market when the emotion of greed was at its peak near the ultimate top, and then not recognising the telltale signs that the party was over. After the crash, they find themselves with large losses and a lesson in mass psychology that commanded a very high tuition fee.
The South Sea Bubble of the 1700s
The South Sea Bubble was another well-known example of human greed ultimately resulting in human misery. The history of the South Sea Bubble is somewhat complex. The bibliography presented at the end of this article lists some books to read – and some of these classics were written centuries ago!
Whereas tulip mania involved greed driving up the price of tulip bulbs, the South Sea Bubble involved the formation of companies and the trading in their shares. At the peak of the bubble, members of the public were clamoring for shares in companies for the:
- Trading of hair;
- Importation of jackasses from Spain;
- Extraction of silver from lead; and
- Manufacture of a perpetual motion wheel.
The most ridiculous was a company that sold 100 pound shares. People paid a two percent deposit, with a guaranteed return of 100 pounds per annum. What was the nature of the company’s business? It was to be “a company on an undertaking of great advantage, but nobody to know what it is.” (That sounds a little like some of the Internet companies – but, of course, it couldn’t happen today, could it?)
In this example the shareholders in this company lost everything. The underwriter disappeared with the money.
Sir Isaac Newton was reported to have lost some 20,000 pounds speculating in bubble stocks. He was later to say: “I can calculate the motions of heavenly bodies, but not the madness of people”.
The Florida Land Bubble
In the early 1920s Florida land prices rose exponentially, and ultimately crashed. The bubble started when farmers bought Florida land in order to enjoy the warm winters while their land was dormant. The farmers were later followed by city dwellers and prices started to increase rapidly. At the peak of the boom, one third of the people living in Miami were real estate agents.
Houses were built at an ever-increasing rate, and once almost worthless swamp land became very valuable. The bubble burst when a hurricane destroyed many houses.
Groucho Marx lost a very large sum of money in the resulting crash and found it to be anything but a laughing matter.
The Stock Market – 1929
The roaring 20s was certainly a decade for speculation. Everything seemed to be booming. The hit song written in that decade which best describes it was ‘Happy Days Are Here Again’. Celebrities like trading genius Jesse Livermore, and the ‘World’s Greatest Entertainer’, Al Jolson, were all at their peak.
The Dow Jones Industrial Average had risen to a peak of 381 on 3 September 1929, and the well-known stock RCA had risen from $94 to $505 in just 18 months. Happy days were indeed here again.
All speculative manias must end. The stock market crashed in late October 1929, with the real erosion of prices occurring in the run down to the final bottom in 1932. From its peak of 381, the Dow fell to 41.
RCA, which had peaked at $505 in 1929, traded at $2 in 1932. For those who believed in a ‘buy and hold’ strategy (as opposed to following a clear sell signal), all was not lost. Those who bought at the top could have waited for the stock to recover, and it did – had they been willing to wait 67 years!
The ‘Tronics Boom
In the early 1960s a boom occurred in so-called technology stocks, particularly those with ‘trons’ (such as Transitron, Astron and Vulcatron) or ‘onics’ (such as Supronics, Circuitronics and Electrosonics) in their name. Speculators and fund managers alike aggressively accumulated these stocks.
The bubble burst in 1962. Many stocks later sold for less than 10 percent of their peak price.
The Poseidon Boom
In Australia, the nickel stock boom of the late 1960s resulted in some nickel stocks experiencing spectacular increases in price. The best known, Poseidon, rose from $1.85 on 26 September 1969 to its high of $280 on 10 January 1970. Some years later it went off the board. Its shares were worthless.
The Stock Market – 1987
1987 produced another stock market crash. Like 1929, it was a period when much borrowed money was used to buy stocks. It was also a period when stock index futures were used for speculation, and program trading became a way to ‘easy’ money. Unlike 1929, the world did not plunge into depression. In fact, the United States stock market took only a couple of years to exceed its 1987 peak. The Australian stock market, however, took more than 10 years to exceed its 1987 peak.
The Internet Boom
The late 1990s and early in the Year 2000 saw many stocks associated with the Internet achieve exponential increases in price. Like all previous speculative bubbles, greed quickly replaced logic.
One example of the rise and fall of the dot.com fortunes was the case of two men in their early 20s who both became overnight millionaires when they floated their Internet company Theglobe.com.
The share price of Theglobe.com gained 606% on the first day of trading. Such price increases are clearly non sustainable. Since the peak, the price of Theglobe.com shares has fallen 98.5 percent.
Since the dot.com bubble deflated, more than 100 United States Internet companies have ceased trading, or are in serious trouble and are desperately looking for new sources of finance. The Law of Gravity has not been repealed – even in the Year 2000.
Just as ‘tronics’ added to a company name sent stock prices skyward in the Tronics Boom, in the late 1990 companies clamored to become, or to be perceived as being, Internet stocks. It was dot com mania. As with all manias, when a chart looks like an exponential growth curve, and a trend line of the most recent market action rises at an almost vertical angle, the end is near.
As the market became more and more overheated, experienced traders started to see the danger signs. Did you observe the following?
- The number and size of new Internet floats (initial public offerings)? Few owners would float their company in a very weak market. As a strong bull market matures, the number of floats, per month, start to rise rapidly.
- The spectacular success of many floats, and the accompanying reports that people were making ‘easy money’?
- The television coverage of children making thousands of dollars trading the stock market.
- The coverage of the new breed of so-called day traders who resigned from their jobs to trade full time.
- Talk of ‘old’ versus ‘new’ economy stocks, somehow suggesting that you had to purchase the new economy stocks to be ‘cool’.
- The playing down of the importance of company earnings in justifying the price of so-called new economy stocks.
- Charts, such as the Nasdaq chart, rising in a parabolic manner to a point where its final trendline on a daily chart was almost vertical.
- And so on.
If we were to draw a chart of the price of tulips before, during and after tulip mania, it would look something like this:
A Typical Boom/Bust Cycle
‘A’ represents the relatively stable price of tulip bulbs prior to them being used as a commodity for speculation.
‘B’ represents the parabolic rise in the price of tulip bulbs. Buyers act like fish in a feeding frenzy. Greed is the predominant emotion driving the market.
‘C’ represents a pause in the rapid price movement, as buying and selling pressure is in a temporary state of equilibrium.
‘D’ represents a crash in the price of tulip bulbs. At this stage fear has turned into panic, as people desperately try to sell any bulbs they may still have.
‘E’ represents the new, sustainable price equilibrium between buyers and sellers. This is often about five percent of the highest price reached.
In reality, the chart of tulip bulb prices is a chart typical of a ‘bubble’, or ‘speculative mania’. The shape is remarkably constant – only the price scale and time periods change.
The other constant is the group of people who inevitably say in Phase ‘B’ “but it is different this time”. These people are not as confident in Phase ‘D’!
The merchants in the temple of boom use a range of methods to extract money from their clients. These will be examined in Part B.