By September 1720, the issue price had reached £1,000, an eightfold increase in six months. Sharply rising prices always catch the attention of the financial community, but this was something different. Talk of the South Sea boom was on everyone's lips. The mania developed to such an extreme that it became unfashionable not to own shares. There was, therefore, a strong social, as well as financial, pressure to go along with the scheme. In the Florida land boom, anyone who stepped back from the crowd and viewed the situation objectively could see from such a simple statistic as the broker-resident ratio that the situation had reached an unreal stage. The same could be said of the South Sea Bubble. At the height of the mania, the value of the company's stock was the equivalent of five times the available cash not just in England but in the whole of Europe. It is obvious with the objectivity of hindsight that this was an unrealistic situation. However, it is difficult for investors caught up in such a flood of emotion to become detached because they are continually being proved wrong by higher and higher prices.
Responsible people who correctly identify such bubbles are often taken seriously at first but are later ridiculed as prices work their frenzied way to their peak. Commentators such as Le Bon and Neill have noted that there is a relationship of sorts between the degree to which a mania can develop and the ability of people to back up their beliefs in that mania with facts. For example, if I look out of my window and see a green lawn, it will be difficult for anyone to persuade me that it is a swimming pool. I know from experience what a lawn looks like, and it is nothing like a swimming pool. On the other hand, if the facts are debatable, such as the future growth of the South Sea Company, it is possible that I could be persuaded to make an investment. My broker, for instance, could point to some new arguments of which I was previously unaware. If I can see that the company has had a good record and that the price has consistently advanced, I may become more interested. When I hear that prominent investors are also on board and that everyone around me is positive, the idea becomes very difficult to resist. When the question becomes not whether the price will go up but when and by how much, it is time for some reflection and objective thinking.
As 1720 progressed, belief in a bright future began to grow, so it was only natural for others to issue new stock in the hope that investors would bite. Greed, it seems, has no bounds because fast and easy gains become addictive. Flotations began for all kinds of projects, and companies were organized for such endeavors as draining Irish bogs, importing jackasses from Spain, and trading in human hair. It didn't much matter what the company was going to do. There was a surplus of funds and few places to put them, so a public that had already seen shares in the South Sea Company skyrocket, was anxious not to miss out on the next investment boom. Once again, we see the law of supply and demand coming into play, rising prices in the South Sea Company raised the prices of equities in general. Other companies were then in a good position to bring their stock to market. These new issues quickly sopped up the surplus funds just as did the marginal land in Florida and the silverware in 1980. The craze seemed to reach its height when a London printer decided to float an issue offering investors the opportunity to participate in "an undertaking of great advantage." Even though no one actually knew what it was, he raised £2,000 in six hours, a huge sum in those days. He then left for Europe and was never heard of again.
This increase in fraud is typical of the later stages of a financial mania as an ever-gullible public becomes an easier and easier mark. The fraud was not just confined to small operators but by now had extended to the directors of the South Sea Company itself. They had bribed many public figures to get the concessions they needed but were now irritated by the way these new companies were absorbing money that would otherwise have gone to supporting the price of South Sea Company stock. In taking steps to expose some of the frauds being committed by the smaller "bubbles," the directors raised some questions in the minds of their own shareholders as to whether the South Sea Company was just a giant version of the newcomers.
Within a month, the mood had quickly reversed as people finally began to question the willingness of Spain to grant concessions. Positive rumors were replaced by negative ones, and the price of the stock began a precipitous slide. By the end of September it had reached £129/share. Thousands of investors were ruined, and a government investigation found that there had been widespread fraud. Many banks had loaned money on the basis of collateral provided by South Sea stock. When the stock tumbled there was no collateral, and so many banks failed. Even the Bank of England itself narrowly escaped financial ruin.
Ingredients for a Mania
These are two examples of financial manias. 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 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
1. A believable concept offers a revolutionary and unlimited path to growth and riches.
2. 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.
3. 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.
4. 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.
5. The price fluctuates from traditional levels of overvaluation to entirely new ground.
6. The new price levels are sanctioned by individuals considered by society to be leaders or experts, thereby giving the bubble an official imprimatur.
7. 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.
8. 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.
9. 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.
10. 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.
11. 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. We have already seen that fraud played some part in the South Sea Bubble and the Florida land boom. The Mississippi scheme was also based on similar practices.
12. At the height of the bubble, the possibility exists that even the most objective person can come up with a simple but eyecatching statistic proving that the madness is unsustainable. The broker-resident ratio in Florida in the 1920s and the value of South Sea Stock relative to Europe's total available cash are two examples. In our own time, we note that in the late 1980s, the value of the lan
d 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
1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
Some Further Thoughts on Contrary Opinion
The preceding examples represent extremes, but the basic tenets just listed are common to all market trends and fads. In the case of manias, we are dealing in years, but many market movements develop in a much shorter time and are far less intense. In his classic book The Art of Contrary Thinking, Humphrey Neill states that the theory is based on several of what he calls "social laws."
These are:
1. A group of people, or "crowd," is subject to instincts that individuals acting on their own would never be.
2. People involuntarily follow the impulses of the crowd, that is, they succumb to the herd instinct.
3. Contagion and imitation of the minority make individuals susceptible to suggestion, commands, customs, and emotional appeals.
4. When gathered as a group or crowd, people rarely reason but follow blindly and emotionally what is suggested or asserted to them.
In practicing the Theory of Contrary Opinion, we must first be aware of these laws and then structure our thinking to put ourselves in a stronger position to combat them. This means, for example, that we need to be skeptical of the headlines and must try to identify the reasoning behind them. Obviously some common sense is in order. For example, if we read the headline "Plane Crash Kills Five Executives; Stock Price Plummets," the chances are good that the crash has been caused by some mechanical or human failure that has nothing to do with the operations of the company. On the other hand, "Chairman Fires CEO; Stock Price Plummets" may indeed require a closer examination. The market has taken the firing as an indication of civil war within the company and so the stock has declined. On the other hand, perhaps the chairman is sending a signal to the world that a constructive shakeup is underway from which the company will eventually benefit. The lesson is that we should not take a negative stance just because the news seems bearish and prices decline. Perhaps such a view would be justified, but we should at least take a look at the opposing case before taking action.
Of course, it is very difficult to take an opposite view from those around us because evidence of the new contrary trend has not yet emerged, either in the form of a change in the price trend or in the facts themselves. In the case of the CEO firing, it may take months before the results of the shakeup and the rationale behind it begin to emerge. It is good to remember that the crowd will already have sold the stock in anticipation of the worst, so the selling will be over long before the turnaround is apparent. The market, like a good contrarian, anticipates what will happen.
It is very difficult for most of us to anticipate a future event by taking action right now, even when the event is more or less certain to take place. For example, we all know that the grass will begin to grow again in the summer, but how many of us take the time and effort to buy a new lawn mower when there is a sale on mowers in January? A few farsighted souls take advantage of this type of deal but the vast majority of us wait until the last moment, even though we know that logically we should buy ahead of time at the more advantageous price. It does not require a great leap of imagination to see how difficult it is to buy into a stock when there is absolutely no certainty of the expected outcome.
Further compounding our reluctance to act is the attitude of those around us. By definition they will almost always disagree with our contrary opinion, sometimes violently. Occasionally the vehemence of the response is itself a sign that you might be on to something. I remember writing a bullish bond article for Barron's in 1985. The following week a reader felt so strongly about the article that he wrote a poem denouncing it. In the late 1980s, Bob Prechter, the well-known market letter writer wrote a bearish article on the gold price for the same publication. He suffered a greater tirade. Both articles turned out to be accurate. I can also point to articles with incorrect predictions where there was no response or outburst whatsoever.
One other difficulty in taking a contrary stance is that it often takes a long time before your view is vindicated. It is only natural for this to underpin your faith, because you begin to fear that these contrary views have no basis. Starting off on the path of contrary thinking is quite difficult, because man is a habitual animal. William James in an essay entitled "Habit" noted "the universally admitted fact that any sequence of mental action which has frequently repeated tends to perpetuate itself; so that we find ourselves automatically prompted to think, feel and do what we have been accustomed to think, feel or do under like circumstances, with out any consciously formed purpose, or anticipation of results." As Neill pointed out, "Habits push our minds into ruts-and it takes a considerable amount of force and time to get out of the ruts." Consequently, if we wish to think differently from the crowd, we need to develop a mechanism to stop us from slipping back into bad habits.
Neill cites some additional reasons for our failures to anticipate. First, individual opinions are of little value since they are so frequently incorrect. Second, human character weaknesses such as fear, greed, pride of opinion, and the like prevent the average person from maintaining an objective stance. He opined that "subjective reasoning leads to opinionated conclusions." Third, if we stand stubbornly by our own opinion, we are likely to defend it regardless of its merit. Many of us are unwilling to admit a mistake.
Neill concluded that if individual opinions are so susceptible to flaws, one should "go opposite" to the crowd, which is so often wrong. This is not as easy as it sounds because you cannot go opp
osite if you haven't successfully dealt with your own biases. For example, if you hold the view that gold prices are in a bull market, it will do you little good to hunt around for bearish articles and then declare yours to be a contrary view. In this case, you would have made the facts fit your own opinion instead of forming your opinion from the facts.
By the same token, it does little good to say, "I'm bearish because everyone else is bullish." This may be correct but we have to remember that the crowd is right during the trend and is only wrong at both ends, that is, when it really counts. We still need to justify our bearish view based on a logical and well-reasoned argument.
In 1946, the Securities and Exchange Commission examined the mailings of 166 brokers and investment advisors during the week of August 26-September 3. Of that number 4.1% were bearish. An investor could certainly have used this survey as a basis for believing that the crowd was positioned in a bullish direction. This belief also could be backed up by facts: The Federal Reserve Board had already indicated it was tightening monetary policy by raising the discount rate, equities were selling at an expensive price/earnings multiple, and some speculation had begun to appear. The market declined by 26 points, the next week, and the bear market was underway.
It is not so much that nearly 96% of the brokers and advisors were bullish but more that their opinions were either influenced by or reflected the opinion of the vast majority of market participants. Thus virtually everyone who had contemplated buying had already done so. Once the smoke had cleared, people began to anticipate a tighter Federal Reserve rate; they could now "see" that stocks were overvalued, and the market began to decline. In effect, the argument on which the bullish case rested could no longer hold water.
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