September 8, 1999


panicn1 : a sudden overpowering fright; esp : a sudden unreasoning terror often accompanied by mass flight 2 : a sudden widespread fright concerning financial affairs and resulting in a depression of values caused by violent measures for protection of securities or other property
- Webster's Seventh New Collegiate Dictionary
Why do speculative markets always end in panic selling? Think of speculators as players in a game of musical chairs. The chairs represent the safe positions where a nimble investor winds up with cash proceeds from the sale of their securities, before the music stops. The players left standing are stuck holding their securities for lack of buyers, as prices drop 20%, 40%, 60%, 80%... In a selling panic, sell orders far outnumber buy orders. A market with few short sellers is the most prone to a catastrophic fall because a short seller represents a buyer at a lower price. A lack of short interest in a market portends a falling market with few natural brakes.

When the game is on, the players circle the row of chairs while an orchestra comprised of financial services employees play in concert with the financial media, financial planners and other groupies circling the chairs. Brokers, press agents, market analysts, and others involved in marketing and selling equities-based financial products add harmonies. Those who don't play off the same sheet music are labeled "contrarian" and are sent off to remote Web sites, where they make their odd sounding music in obscurity.

Here's how the popular press plays along. Late August/early September 1999, the Dow dropped several hundred points. The talking heads on CNBC said, "Don't worry.  The trading is light. This volatility comes from amateurs trading in the absence of professional money managers who are all on vacation. When the pros get back from the Catskills, volumes will rise and volatility will fall." Then the amateurs exploded the market upwards more than 200 points on Friday, still before the pros returned from vacation. CNBC announced, "The market has resumed its rise." Reporters trumpet a rise in the market more significantly than a fall under the same conditions -- market reporting with a bullish bias. St. Louis Fed economist Emmons reported one week later, "The party for stocks seems to be over but people won't go home because they just don't seem to know it's over yet." But how are people going to know the game is over if the press keeps telling them the game's still on?

Why does the popular press play along? In a speculative market, the audience for negative, or even skeptical, coverage is small and thus uninteresting to large media organizations, especially those whose stock is publicly traded. No more need to explain this to a reporter or editor than a dog needs to be told that biting the baby will result in a short career as the family pet. Unlike the popular media outlets and especially television, the professional financial press -- the Wall Street Journal, Barron's, and The Washington Post, and this magazine, for example -- diligently air evidence that the game has run its course. But do the majority of players in the game read these publications?

Central bankers want to appear hands-off and disinterested, focused only on economic models that inform them as to whether they have achieved their aims of price stability and low inflation in the real economy, ignoring the stock market. They mostly go along with the game without playing in the orchestra, occasionally plucking a sour note by pointing out that the game may be nearing the end. But the participants hardly notice, such is the volume of the vast orchestra of television, newspaper, and magazines, financial planners and authors, of brokers and trading firms.

But no matter how many chairs the game begins with, no game of musical chairs can last forever. Sometimes gradually and sometimes suddenly, the orchestra begins to play off-key. A gentle rain has begun to fall and musicians can no longer read their sheet music. The music becomes dissonant. Confused, the participants look to each other for cues. The music's going to stop soon.

A speculative stock market is unlike musical chairs in one critical respect.

An investor takes money out of his pocket to buy stock. He thinks he still has that much net worth, but all he has is equity paper instead. If the price of the stock goes up he thinks he has more net worth. He can even use the stock as collateral to borrow more money to buy more stock.

Meanwhile, the original money he spent to buy the stock goes to the guy he bought the stock from. The stock seller might put the money in the bank where someone else will borrow it or he might buy the same stock himself, helping to drive the price up some more. Now the guy he bought the stock from has the money he got from the first guy he sold the stock to. And so on.

Add up the money that everyone thinks they've got and it's far more than what's really circulating. As long as the boom continues everything is fine and the apparent wealth grows.

What happens if a significant number of people all want to make a withdrawal at the same time? That's when all the apparent wealth disappears.

It's a chain reaction. Collateral is gone so margin calls are generated. More withdrawals. More chain reaction.

Funny things happen. Some positions are short positions or hedge positions. When they get covered the price of the affected item goes up.

When the bust finally runs its course a few lucky people who were in the right musical chair at the time have all the original money that was used to buy the stocks.  The others go bust. Wondering where it all went. That's how guys like Rockeller and J. P. Morgan got their fortunes just before what was The Great Depression for everyone else.

The Fed can and will move to drop interest rates to provide liquidity to meet the demands for cash that occur in a stock market panic. But there is a point at which you're going to go over the falls no matter how hard you paddle.

- Gollum
The game of stock market mania musical chairs is unlike the parlor game in another important respect. Rather than ten players and nine chairs, there are ten players and only one chair. If you are still in the game at the time this is published, that means you believe either the music will never stop or that you are quick enough to beat the other nine players to that one chair when it does.

Once the stock market speculation game is over a new game will begin. Will it be a bond game? A commodity game?  I expect a commodity game as the world's dollar money supply is increased to counter deflation, and U.S. interest rates are raised to defend a falling dollar, after the equity speculation game ends. Whatever the new game, a new group of players who were not financially ruined in the last game will come out to circle a new chair in the next speculative game. The financial services orchestra will strike up a new tune -- new products, brokers selling them, reporters covering them, central bankers on the sidelines.

The course of human history, while on an inexorable upward trend, is dotted with occasional setbacks from the aftermath of financial manias. From the real estate bubble collapse in Athens in 333 BC to the Mississippi Bubble in 1720 to the U.S. Cotton Panic in 1837 to the French Credit Mobilier Debacle in 1868 to the Great Crash here in 1929, to the Japanese stock market in 1990, and on and on, the lessons are ignored and the errors repeated. To the game's participants, every financial mania is new. Perhaps history is not comprised of a series of events after all. Maybe history is a language, one in which the dead speak to the deaf.