November 1998

Extraordinary Popular Delusions And The Madness Of Crowds

"Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. To trace the history of the most prominent of these delusions is the object of the present pages. Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."
- Charles MacKay, 1841
You've heard of the speculative tulip bulb craze that gripped seventeenth-century Holland.  At the peak of the mania, a single tulip bulb sold for the equivalent of $150,000 - $1,500,000, depending on which historian you believe.  This was only one of many speculative financial bubbles that have occurred over the centuries, such as the eighteenth-century South Sea Bubble in England and the 1920s stock market mania in the United States.


Careless Speculation
Today investors spend thousands of dollars on Internet stocks, shelling out $50, $100, or $200 per share and more for stock in an Internet company (Amazon.com) about which they may know almost nothing.  Some of these companies offer services that are easily replicated.  Many do not have credible plans to generate earnings for many years, if ever.  The best, even when they do turn a profit, have market capitalizations that price in the assumption that they will put every competitor out of business -- a highly unlikely scenario.  These factors do not prevent investors from betting heavily on zero future competition and exponential growth in earnings.  Generally, Internet stock investors show no interest the business plans for the Internet companies they invest in.  All they really care about is how liquid the stock is and how many other gamblers are on an Internet chat room talking about it.  Recently a stock in a construction business went up over 20% in one day because its ticker symbol was similar to that of an Internet company that had gone public.  Talk about poor due diligence, thousands of "investors" hadn't even bothered to get the ticker symbol right.
"Fair weather cannot always continue. The economic cycle is in progress today, as it was in the past. The Federal Reserve System has put the banks in a strong position, but it has not changed human nature. More people are borrowing and speculating today than ever in our history.  Sooner or later a crash is coming and it may be terrific."
Roger Babson
September 1929


Greater Fool
When you buy a share of stock, you are purchasing a stake in a portion of the company's assets - tables, chairs, buildings, employees, inventory, etc. A company's stock price normally reflects the market's expectation of the future income the corporation can produce with these assets.  Many Internet companies have a market capitalization of hundreds of millions of dollars but hardly have any tangible assets or any revenue, never mind profits.  The price of many Internet stocks is not based on future earnings potential but on the hope that someone will buy the stock at a later date for a higher price, a greater fool.


The Pin
Speculative bubbles can continue for years on end.  It's impossible to predict when one will end.  The end of the current stock market bubble has been predicted since the mid 1990s, yet it goes on and on.  Eventually, an event occurs that acts as a crash catalyst, a pin that pricks the bubble.  The event presents investors with stark and conclusive evidence that the source of fuel for the speculation is about to be cut off.  For example, if the Fed were forced to raise interest rates to protect the dollar from speculation, the "don't fight the Fed" bull market mantra singers will fall suddenly silent. Buyers of stocks at lower prices will quickly outnumber buyers of stocks at higher prices.  In a financial bubble, this tends to happen swiftly as investors, each knowing they are part of a mass speculation yet believing they alone will get out in time with their profits, suddenly discover that their belief is exactly the same as that held majority of fellow speculators, who then all rush for the exits at the same time.  Prices collapse with breathtaking speed.  It is an awesome event.


Market Boom turns to Market Ka-boom! 
The tulip bulb mania ended in panic selling in Holland when investors suddenly realized that a tulip bulb is not worth $10,000 or $150,000.  Within weeks, prices collapsed.  Investors were left with tulip bulbs valued at only a few cents each. After all, that's what they were worth.  For many careless Internet stock investors, when the Internet stock mania is over they will have little more than a nearly worthless stock certificate to show for their investments.