Crash a la Mode
As far as we can discern, humans are the sole species with the capacity and penchant for creating financial bubbles, though future research may demonstrate other species are equally adept at constructing not just a casino but the mentality that fills it with punters.
The French expression “a la mode” is associated with a scoop of ice cream on a slice of pie in the U.S., but the phrase means in the current style or fashion (mode).
This post is titled Crash a la Mode because manic speculative excesses–only out of fashion after a crash, and then only until memory fades–have been in particularly haute style for the past 30 years.
The psychology of bubbles and crashes might be summarized as viral-manic-depressive, as a manic enthusiasm and confidence is the god-like powers of some new technology or financial innovation to generate fabulous wealth with a few transactional click spreads through the populace like a virulent virus.
I have often noted our hard-wired attraction to unearned windfalls, as a tree loaded with fruit is (in our eyes) begging to be stripped bare, and once we’ve consumed or packed up the bounty, we’re off, eyes peeled for the next easy-picking windfall.
I’ve also noted our social nature, our constant monitoring of what the rest of the herd is doing, and our predilection for the euphoric rush of joining the herd when it’s running.
The fusing of our euphoria in unearned windfalls and the euphoric joys of joining an overwhelmingly enthusiastic herd boosts our confidence that the gains, like the herd, are unstoppable.
Which brings us to the present moment. This post is not about technical analysis, trends, cycles or fundamental analysis–cash flows, price to earnings ratios, etc.
This post is about the near-perfect alignment of the present-day zeitgeist with the final stages of the speculative bubbles of 1998-2000 and 2006-2008, both of which ended in bone-crushing crashes.
The alignment is near-perfect because we’re still running Wetware 1.01. Human psychology hasn’t changed since 2000 or 2008, so it’s entirely predictable that the current global financial bubble will track the previous bubbles.
A few observations stand out.
1. The S-Curve is an imperfect but still useful model of how bubbles arise, stagnate and fall.
In the multi-year ascent/boost phase of the bubble, every crisis, pullback or panic is not just reversed–markets soar to new highs. Those who bet on gravity suffer grievous losses and give up betting on a sustained reversal. Those who buy the dip are richly rewarded.
Those who doubt this can last are decimated and those who think the end of the Bull run is still some distance ahead find their confidence remarkably enriching.
This track record strongly reinforces continuation of the up-trend, as dip buyers will push the market higher, forcing wayward shorts to cover, which pushes markets even higher.
These dynamics are self-reinforcing, and as a result, the necessity of conjuring a plausible financial case for ever higher valuations fades and is replaced by facile cliches–the Federal Reserve’s god-like powers will never allow the market to drop, this is a technological revolution, etc.
In other words, the fundamentals no longer have any impact on behavior, as the participants have simplified the whole thing down to “buy the dip” (or buy more of whatever is going up, or rotate into the next hot sector). This simple rule has demonstrably generated immense wealth, so why complicate things?
2. The stagnation phase is tediously drawn out as Bears have been exterminated and new highs in one sector or another continue to support the Bullish case that markets can climb the wall of worry for years to come.
Even when previously hot sectors decline, “buy” recommendations are steadfast (”buy the dip”) and there’s always a new sector that’s soaring as hot money floods in. The structural decay is hidden or easily dismissed, and so a stock that was a “buy” at $80 per share is now a “screaming buy” at $45.
Unbeknownst to those buying the dip, the stock eventually touches bottom around $5 a share.
3. The breakdown / crash is characterized by thrilling rallies as “buy the dip” is never felled by a single blow; it succumbs only after repeated bouts of doubts and losses. “Buy the dip” is so ingrained by this stage that punters will reckon this decline is the last one and now it’s time to buy the dip. This continues until all the prospective buyers no longer have the means to buy, as their fortunes have been eroded by lower lows and lower highs.
4. No one believes a sustained crash is possible, and so few punters cash in their positions and exit the casino. The confidence of the herd rubs off on us as individuals, and our winnings persuade us we have A) a fail-safe system for trading and/or B) we have an innate knack / genius for trading.
5. Crashes are painfully leisurely. When the first “buy the dip” fails to reach previous highs, few see this as a sign that the entire decline process will stretch out two or three years. The recent past of bubble gains suggests any downturn never lasts more than a few months.
Those counseling caution are dismissed as Perma-Bears who are like a broken clock, occasionally right but useless as market prognosticators.
6. Though we experience pain more profoundly than the pleasures of our gains, we cling to our beliefs about the market with increasing intensity as our losses mount.
In effect, manic speculative financial bubbles detach from the real world and become self-sustaining, as the drivers are our natural tropisms for windfalls, running with the herd and euphoric confidence in our mastery / powers.
Bubbles pop because as real as all these emotions and beliefs are, they push valuations and risks to extremes that no longer align with the real world.
If we plot these points on a timeline, the probability that we’re about to experience a Crash a la mode is soberingly high. The ultimate cause of the crash isn’t an event or financial data point; those are invoked later, to justify the post-crash reckoning. The cause is Wetware 1.01.
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