Waiting to Deflate

We delight in the folly of others. As Charles Mackay wrote in Extraordinary Popular Delusions and the Madness of Crowds, “Is it a dull or uninstructive picture to see a whole people shaking suddenly off the trammels of reason, and running wild after a golden vision, refusing obstinately to believe that it is not real, till, like a deluded hind running after an ignis fatuus, they are plunged into a quagmire?” Mackay’s book, first published in 1841 in three volumes, 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. Mackay, who earned his living as a poet, songwriter, and journalist, wasn’t a rigorous historian. His narrative is strewn with outlandish legends, such as the story of a sailor who, during the Tulip Mania, consumed a rare tulip bulb whose cost “might have sumptuously feasted the Prince of Orange and the whole court of the Stadtholder,” mistaking it for an onion. Though Mackay can still be read for pleasure and instruction, since 1841 there have been many more such manias.

William Bernstein’s The Delusions of Crowds: Why People Go Mad in Groups, whose title is inspired by the earlier work, follows Mackay’s example by mixing tales of well-known speculative manias with accounts of religious awakenings, from the one begun by the Cistercian abbot Joachim of Fiore in the twelfth century to the rise and fall of the Islamic State. 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.

In place of Mackay’s intuitive insights into crowd madness, Bernstein draws on research in the field of behavioral psychology to distinguish between rational and irrational economic behavior. Under certain conditions, groups of people can make amazingly accurate judgments. For example, the statistician Francis Galton, a cousin of Charles Darwin, discovered that attendees at an English rural fair in 1906 who competed for a prize to guess the weight of an ox came up with a median estimate that was very close to the animal’s actual weight. Bernstein, drawing on James Surowiecki’s The Wisdom of Crowds (2004), describes what’s needed for a crowd to give accurate predictions or estimates: it should display “independent individual analysis, diversity of individual experience and expertise, and an effective method for individuals to aggregate their opinions.”

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.”

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.

Manias are diseases of the mind. Popular delusions occur when appealing but baseless stories spread contagiously from one person to another. Some ideas are more virulent than others: people have been found to react most enthusiastically to narratives of fear. “The human preference for bad news,” Bernstein writes, “is so widespread that ‘bad is stronger than good’ has become one of the basic precepts of experimental psychology.”

New technologies have played into this natural preference. It is no coincidence that the witch mania began only decades after Johannes Gutenberg’s invention of the movable-type printing press. The Malleus Maleficarum (The Hammer of Witches), the first printed encyclopedia of demonology, appeared in 1486; as Hugh Trevor-Roper wrote, this book, compiled by two Dominican inquisitors, “advertised to all Europe both the new epidemic of witchcraft and the authority which had been given to them to suppress it.” In his chapter on the witch mania, Mackay describes how “terror seized upon the nations; no man thought himself secure, either in his person or possessions, from the machinations of the devil and his agents.” Across Europe and later in North America, people believed that the earth was swarming with millions of demons, which, like miasma, couldn’t be seen, and multiplied until the air was supposedly filled with them.

Later religious manias described by Bernstein, such as the Anabaptist rebellion in Münster in the mid-1530s and episodes of religious revivalism in Britain and the United States in the eighteenth and nineteenth centuries, were likewise spread by the printed word. More recently, the advent of the Internet enabled the Islamic State to distribute its material, including press releases of the exploits of the “Martyrdom-Seekers-Brigade” and videos depicting attacks on “crusader” troops. The Islamic State’s slick social media campaign attracted converts from far and wide. As Bernstein writes, they discovered that apocalypse sells, and the bloodier the better.

Apocalypse sells, but so does greed, whose appeal, according to Bernstein, is a close second to that of fear. And as with religious manias, 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. In Irrational Exuberance (third edition, 2015), the Yale economist Robert Shiller writes that at the time

we were witnessing another explosion of technological innovations that facilitate interpersonal communication, consisting of e-mail and chat rooms…. These new and effective media for interactive (if not face-to-face) communication may have the effect of expanding yet again the interpersonal contagion of ideas.

Yet speculative manias aren’t spontaneous, self-forming social phenomena. More often than not, they have a guiding hand. Bernstein claims that bubbles consist of “four Ps”: promoters, public, politicians, and the press. Promoters—such as John Law in 1720; George Hudson, Britain’s “Railway King,” during the railway mania of 1845; and Charles E. Mitchell, the head of National City Bank in the Roaring Twenties—direct the public’s euphoria to their own ends. As Dickens wrote in his epitaph to the swindler Merdle in Little Dorrit:

You really have no idea how the human bees will swarm to the beating of any old tin kettle; in that fact lies the complete manual of governing them. When they can be got to believe that the kettle is made of the precious metals, in that fact lies the whole power of men like our late lamented.

Every significant bubble attracts new entrants from across the social spectrum. Estimates of the number of speculators thronging Paris during the Mississippi Bubble run to half a million, although the true number was probably much lower. Over the centuries, the numbers of those exposed to the stock market have increased, both in absolute terms and relative to population size. Whereas around two million Americans owned stocks in the 1920s, during the dot-com mania the number exceeded 75 million, many of them engaged in day trading via online sites that charged less than traditional brokerages. The reestablishment of stock markets in China in the early 1990s, followed by two speculative bubbles, in 2005–2007 and 2014–2015, has led to huge increases in the number of people who own stocks: in just the first five months of 2015, some 30 million brokerage accounts were opened in the People’s Republic.

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.”

Modern economists, who assume that investors are rational agents who maximize wealth while minimizing risk, are uncomfortable with the concept of speculative bubbles. Eugene Fama, who earned a Nobel Prize in economics for his role in developing the Efficient Market Hypothesis, remarked, “The word ‘bubble’ drives me nuts,” and has complained that the term is not clearly defined. In Boom and Bust: A Global History of Financial Bubbles, William Quinn and John Turner cite the definition provided by Charles Kindleberger, the MIT economic historian, who described a bubble as an “upward price movement over an extended range that then implodes.” In other words, a bubble can be identified only after it has burst.

Boom and Bust covers some of the same ground as Bernstein, but its authors reject explanations for bubbles based on investor irrationality. The concept of rationality, they claim, is

almost useless for understanding bubbles…because the word “rational” is so loosely defined that many common investor behaviours can be classed as either “rational” or “irrational,” depending on the preferences of the economist.

This is a fair point: professional investors, who fear that clients will leave them if they underperform, may be forced to buy overpriced stocks to preserve their jobs—that is, they rationally choose to make seemingly irrational decisions. This problem becomes acute when investment performance is measured over the short term; as Keynes observed in his General Theory, most money managers are concerned “not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.” Such behavior makes markets inherently unstable.

Quinn and Turner explain speculative outbreaks by reference to what they call the “bubble triangle,” which consists of marketability, speculation, and money and credit. Marketability, or the ease of buying and selling financial assets, plays an important part in most bubbles, but not in all.¹ What the authors mean by “speculation” is the “purchase (or sale) of an asset with a view to selling (or repurchasing) the asset at a later date with the sole motivation of generating a capital gain”; in this respect, bubbles resemble pyramid schemes in which the early participants profit from those who arrive later in the game. The third angle—the availability of credit and low interest rates—appears key to understanding how bubbles work.

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.² As Bernstein writes, “low interest rates are the fertile ground in which bubbles sprout.”

It is a pity that both Boom and Bust and The Delusions of Crowds went to press before the extraordinary events of this past year. 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.

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. Richard Bernstein, a fund manager and former Wall Street strategist, has recently produced his own bubble checklist, including increased liquidity, leverage (stock purchases made with borrowed cash), market activity, and new assets, as well as the “democratization of the market.” All these bubble conditions are evident today on Wall Street.

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).

Just as day traders boosted market turnover during the dot-com bubble, trading volumes on US stock exchanges have reached a higher level than at any time since the 2008 financial crisis. 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. Whatever one thinks of the sponsors’ motives, their behavior can hardly be described as irrational.

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.

Last December, Massachusetts securities regulators filed a complaint accusing Robinhood of engaging in aggressive marketing techniques to attract inexperienced customers and “gamification” to entice them to repeatedly use its trading application. According to the filing, Robinhood gave “hundreds of customers with limited or no investment experience the ability to make thousands of trades in a matter of months.” One customer with no prior experience is said to have made 12,700 trades in just over six months.

Much as Amazon lists its best-selling products, the Robinhood app lists the most popular trades, prompting more users to buy those stocks, thus increasing their popularity. These include a number of so-called meme stocks such as Tesla, the SPAC electric-vehicle start-up Nikola, the space-travel company Virgin Galactic, and the electronic-games retailer GameStop. Unlike Tesla, GameStop’s brick-and-mortar business model was in trouble and its stock had been heavily shorted on Wall Street. In January a short squeeze engineered by retail investors sent GameStop shares from less than $18 to close to $350, resulting in losses of billions of dollars for one hedge fund. (Bearish traders, who sell a stock short anticipating a decline in the share price, face losses if they can’t find other shares to buy. During a short squeeze, a shortage of shares can cause the price to spiral upward.)

The GameStop craze started with young Robinhood investors coming to the rescue of a familiar company that they saw as being mauled by Wall Street bears. Having tasted blood, they have subsequently produced a number of other short squeezes. AMC Entertainment traded at $2 in January; by early June the stock had risen to above $60. When AMC’s management took advantage of the rising share price to issue more stock, one shareholder complained on Twitter, “Seriously we got the company this far let us have our squeeze.”

Speculative manias often exude a carnival-like atmosphere as the financial world is turned upside down. This time is no different. On WallStreetBets, a forum on the popular website Reddit, investors swarm to discuss the next trade. Styling themselves as social outcasts, “autists,” “retards,” “apes,” and “degens,” they pour scorn on traditional investors. Their rallying call is YOLO—you only live once. A popular stock promoter on Twitter, Dave Portnoy, who goes by the name “Davey Day Trader” (and was already well known as the founder of the media company Barstool Sports), posts videos of himself selecting stocks by picking Scrabble letters from a bag. “The good news,” tweets Portnoy, “is that I know it’s rigged…the stock market is disconnected from reality. The whole thing is a pyramid scheme. We’re living in the Matrix.” In the world of Robinhood, speculation has become an act of rebellion against a corrupt system.

The US stock market has recently traded close to record highs on just about every traditional valuation measure, such as the total value of US companies relative to GDP and cyclically adjusted earnings. The latter measure, known formally as the cyclically adjusted price-to-earnings ratio (CAPE), was devised by Robert Shiller; it calculates average profitability over the course of the business cycle. According to the CAPE measure, the US stock market is above its 1929 peak and close to its all-time high at the end of the dot-com bubble. Another measure based on the value of corporate assets—known as Tobin’s q, after another Yale economist, James Tobin—tells a similar story of overheated markets.

This most perfect of speculative bubbles has been formed by many factors: exciting new technologies, such as electric vehicles, that promise to change the world but whose future profitability remains uncertain; the Internet and widespread smartphone use, which allow ideas to spread with unprecedented speed; social networking techniques that are now influencing investor behavior; and investment superstars such as the technology investor Cathie Wood of Ark Invest and Chamath Palihapitiya, a serial sponsor of SPACs, both avid users of Twitter. (Chamath, as he is familiarly known, is a former vice-president for user growth at Facebook.) Above all, trillions of dollars of low-interest money are available. Shiller has suggested that the current low yields on US Treasury bonds justify higher share valuations, but such reasoning assumes that interest rates will remain low in the future.

Robinhood says that it is on a mission to democratize investment. But as Quinn and Taylor demonstrate, similar claims were made during previous bubbles. (Their chapter on the English railway mania of the 1840s is entitled “Democratising Speculation.”) Research suggests that individual investors who trade frequently and hold unbalanced portfolios generally underperform the market. 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.³ As with Facebook and Twitter, Robinhood’s users are the product. If history is any guide, this won’t end well.