Manias, Panics and Crashes (updated 22 Feb 99)

Financial markets are particularly susceptible to manias, panics and crashes, where asset prices rise to extraordinary heights only for confidence and greed to turn to fear and despair, sending the market into freefall. One of the first analysts of these phenomena was Walter Bagehot, nineteenth century editor of The Economist. His 1873 book, Lombard Street, is a powerful account of the psychology of financial markets: how investors overdose on hope and then despair, and how central banking may, to some degree, restrain self-destructive cycles of elation and panic.

Many of the classic stories of market mayhem are told in Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds, written in the 1840s. This study of crowd psychology and mass mania through the ages includes accounts of numerous market scams, madnesses and deceptions, notably the Mississippi Scheme that swept France in 1720; the South Sea Bubble that ruined thousands in England at the same time; and the Dutch tulipmania, when fortunes were made and lost on single tulip bulbs.

More recent histories of these extraordinary events include Martin Fridson's It Was a Very Good Year and Manias, Panics and Crashes by economist Charles Kindleberger. Kindleberger argues that there is a consistent pattern to financial manias and panics - quite apart from the ebb and flow of the business cycle - which can be controlled or moderated. He spells out the stages of the credit cycle of boom and bust:

· The upswing usually starts with an opportunity - new markets, new technologies or some dramatic political change - and investors looking for good returns.

· It proceeds through the euphoria of rising prices, particularly of assets, while an expansion of credit inflates the bubble.

· In the manic phase, investors scramble to get out of money and into illiquid things such as stocks, commodities, real estate or tulip bulbs: 'a larger and larger group of people seeks to become rich without a real understanding of the processes involved'.

· Ultimately, the markets stop rising and people who have borrowed heavily find themselves overstretched. This is 'distress', which generates unexpected failures, followed by 'revulsion' or 'discredit'.

· The final phase is a self-feeding panic, where the bubble bursts. People of wealth and credit scramble to unload whatever they have bought at greater and greater losses, and cash becomes king.

Guru of manias, panics and crashes: Marc Faber

It is a German rickshaw, this white 'fully dressed' BMW K1000 weaving in and out of Hong Kong traffic. From under the helmet, the driver's ponytail bobs in the wind. No, the costume is not worn by the local constabulary but might well be a Chinese meditation gown. Where could the driver be going through the financial canyons on the Hong Kong side of the island? Surely not to the Stock Exchange building towards which he is headed, but most likely to the Bank of China building to bless some new function in its China Club.

The driver parks in a tiny space and races to an investment lunch where, of all things, he is the prestigious speaker. He is Marc Faber, Swiss by birth, oriental by self-selection, revolutionary art collector, economic historian and contrary investor to his core. Faber can expound on price indices in the first millennium after Christ, the latest technical patterns in the Malaysian market and the inner workings of China from his perch in Hong Kong. His clientele read his volumes and are devoted to his admonitions that one must flee the crowd to succeed. After turning his back on emerging markets, his forte, when they became popular, he went into Africa in a quest for the unexploited.

When cultural, economic and technical tools are blended in an inquisitive mind, one can learn some powerful market insights. For some, the wrappings of Faber's views are jarring, but to others they are an invitation to come on in to see some different facet of the world investment scene.

Faber really knows and, as his sometime label as 'Doctor Doom' suggests, enjoys the extreme events of manias, panics and crashes. His monthly publication, The Gloom, Boom and Doom Report, is full of insights into market psychology as the following extracts on the characteristics of a speculative mania illustrate:

'In a buying frenzy, there is, through the effect of contagion, a universal urge to participate in the whirlwind of speculation. No one wants to miss out: the public because it sees only profits and no risks and argue 'what else can I invest in - there are no alternatives'; the corporate sector because it overestimates the demand for its products or is overly optimistic about future prospects; and the professional investors because they cannot afford to be out of a rapidly appreciating market.'

'Near-term performance orientation, indexation, and money flows into the best performing funds force them to be in sectors which have the strongest upward moves. In a mania, therefore, the expression one hears again and again is 'we cannot afford not to be in the market' or 'we cannot afford not to be in this sector.'

'Characteristic of every investment mania is the formation of investment pools and a rising number of new issues flooding the market. During every manic phase, cash is always regarded as a totally unattractive investment alternative.'

'At the end of an investment mania, corporate insiders step up the selling of their company's shares, recognizing their overvaluations, or in anticipation of less favorable business conditions. Also symptomatic are pros who turn bearish too early, sell short and get very badly squeezed.'

Counterpoint

The common theme of investment manias is that investors' enthusiasm for the market - whether it is for stakes in emerging economies, internet stocks or whatever - rapidly loses touch with the reality of what it is they are buying, even when the concept they are buying has some validity (see EMERGING MARKETS and INTERNET INVESTING). But does that mean that they are behaving irrationally, bucking the central notions of economics, or are there sane reasons for insane markets?

Many of the behavioral finance ideas discussed in our INVESTOR PSYCHOLOGY chapter, such as overconfidence and anchoring, can help explain the phenomena of manias and panics. For example, up or down, the market may have the right reaction to news but wildly overreact, or it may get the basic reaction wrong and/or ignore crucial bits of information. There might also be gambling on the upside, with some investors doubling their bets in a rising market, attracted by the thrill of winning and the whiff of danger.

In effect, bubbles and crashes are the 'tails' of investor psychology, where herd behavior leads to extreme outcomes, first on the upside and then on the downside as confidence turns to panic. Economists use the term 'multiple equilibria', where small jolts can knock the economy from a high profit equilibrium to a low profit equilibrium, and where the fear of jolts causes market gyrations.

But what is the relationship between 'rational' individuals and the irrational whole? First, people change, starting off rational but then losing contact with reality. Second, rationality can differ among different groups. And third, everyone succumbs to the 'fallacy of composition': each individual decision can be rationalized but not the whole.

The Asian crisis of 1997-8 and its fallout in Russia, Latin America and even in the United States with the near-collapse of Long Term Capital Management, suggest that the credit cycle of mania and panic continues today on a global scale. But is it a traditional credit cycle? There are a number of reasons for thinking not:

· The period of expansion has been very long - perhaps fifty years by the post-war measure or twenty-three years, since the early 1970s, by another. Managers have not been trained by previous credit cycle experience.

· Interconnections are stronger, quicker and tighter than formerly with new institutions in the loop.

· With more instruments in the financial system, each can 'create' money of an unknown amount. There are no data nor estimates of velocity, amounts or leverage, and we do not know about correlations under 'stress', the tails of the distribution.

· In the United States at least, the public is 'in'. Equities are a key part of savings, which makes a crisis vulnerable to political solution, possibly compounding the problem.

· The global central bank, the IMF, is not powerful enough against the speculators to give confidence to the markets.

Guru response

Marc Faber comments: 'A tidal wave of speculation raised the Japanese stock market in the late 1980s, then moved on to the emerging markets in 1993, and seems to have now reached the shores of the United States.'

'Today, a wave of optimism and new era thinking is sweeping through the investment community. The breakdown of communism, the opening of a large number of new markets, promising new technology, corporate downsizing and layoffs, the lack of any military threat, low inflation, falling interest rates, globalization, free trade, etc., are expected to bring about endless profit opportunities. Thus, Wall Street, led by the more speculative NASDAQ index, has displayed a stunning performance since 1990. But could we, today, be caught in a financial bubble which occurs once a generation and which will end the way previous new era-based bull markets have ended?'

'I really have no idea how many more investment books have to make the bestseller list and by how much more the shelf space they occupy in bookstores has to expand, or how many more times successful investment managers, technology companies and the internet will have to appear on front covers or make headlines, or how much more crowded high tech conferences will become before it all ends, but clearly, the symptoms are awesome.'

Where next?

Are there investment strategies that can take advantage of manias and panics? For contrarians like Marc Faber, who was bearish about the Asian markets for some while before the crisis began in July 1997, there are certainly opportunities. But as with all contrarian investing, it takes an unusual mindset to take positions against the views of the majority (see CONTRARIAN INVESTING).

And there is some dispute about whether events like the Asian crisis really constitute market manias and panics. There are essentially two views: first, that it was just like a nineteenth century British bank panic, calling for prompt action by a global 'lender of last resort'; and second, that it was much worse - nothing less than the bursting of a new South Sea Bubble, a latter day long wave cycle of liquidity evaporation, not reallocation.

Jeffrey Sachs is associated with the first analysis. He stresses the liquidity crisis facing the emerging Asian economies as foreign short-term credit was withdrawn in what he calls a creditor panic. Such 'coordination failure' on the part of creditors can be appropriately handled by injecting liquidity - or by forcing creditors to rollover their loans - as Bagehot pointed out. But if the panic is triggered by fundamentals, then structural change - not just liquidity - is needed.

What if, for example, global capital had been lured by tales of miraculous growth to pouring money into a spectacular but unsustainable Asian bubble? When this bubble ended, then - just as in Japan in 1989-90 - financial institutions would face more than a liquidity problem: they would collectively be bankrupt. And even institutions that are not bankrupt might face incentives to gamble. This account, championed by Paul Krugman, helps to explain why the IMF was unwilling or unable to throw money at the problem.

The Asian crisis points out two emerging features of the global financial landscape: deflation and nationalism. Asian countries, and almost all developing economies, sell a deflating commodity: low wage labor. They also sell commodities, which, along with the labor, have entered a long, steady decline in realizable prices. Faced with having to beg for money to stabilize, not just to grow, these countries increasingly fall back on their own resources.

As much to avoid IMF lectures as for economic purposes, countries like Malaysia are pulling back from the global community and the global idea of free and open markets. For example, Malaysian Prime Minister Mahathir Mohamad has imposed currency controls to protect his country's foreign reserves. Others may be considering the same move, which may be an end to the world's goal of a freely floating world monetary system.

The Asian crisis also indicates the dangers of financial market bubbles and crashes to the rest of the economy. Faber argues that 'major manias are usually once-a-generation affairs and lead to some serious economic damage once they come to an end.' And John Kenneth Galbraith's classic account of the Great Crash notes the five weaknesses of the 1929 US economy, which led from the crash to the Depression of the 1930s: an unequal distribution of income; bad corporate governance; a weak banking structure; a 'dubious' balance of trade position; and bad economic advice.

Read on

In print

Walter Bagehot, Lombard Street
Marc Faber's monthly newsletter, The Gloom, Boom and Doom Report
Martin Fridson, It Was a Very Good Year: Extraordinary Moments in Stock Market History
JK Galbraith, The Great Crash 1929
Charles Kindleberger, Manias, Panics and Crashes: A History of Financial Crises
Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds
Nury Vittachi, Riding the Millennial Storm: Marc Faber's Path to Profit in the Financial Crisis

Online

www.marcfaber.com - Marc Faber's website
web.mit.edu/krugman/www - Paul Krugman's website
www.stern.nyu.edu/~nroubini/asia/asiahomepage.html - Nouriel Roubini's website, which brings together key writings on the Asian crisis and its aftermath