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Bubblemania And The Market Crash

Stock-Markets / Financial Crash Apr 25, 2013 - 08:13 AM GMT

By: Andrew_McKillop


Stock markets are at all-time record highs, yet the real economy is anemic as is clearly shown by constantly "unexpected" or "disappointing" GDP growth figures in almost all countries. As we know, one major fetish cant-lose asset bubble, after another, will suddenly weaken and collapse but the equity markets confortingly roar on and up, unperturbed. Looking at the cant-lose asset bubbles since year 2000, we have had the Internet dot com bubble, real estate in a string of countries and arguably a major cause of the 2008 crash, the uranium bubble of 2005-2007, oil prices in 2004-2008, the green energy and cleantech bubble of 2007-2012, gold price growth for nearly 11 years, the ongoing Bitcoin craze, and other cant-lose assets whose prices "could only grow". Until they wilted or even collapsed.

In this unprecedented period of uncertainty, and volatility as shown by the VIX, a common question is “What will work right now?” The best answer to this is what veteran investor Sir John Templeton said about euphoria:

“A bull market begins pessimistic, grows on skepticism, matures on optimism and dies on euphoria.”

Probably the biggest problem for us is how we measure euphoria. There are volatility indexes and measures, but not a euphoria gauge - other than equity index numbers. More important, we have no concrete or credible explanation of euphoria, or reason to be euphoric at this moment in time.

In his book "A Short History of Financial Euphoria", J. K. Galbraith looked at significant episodes of speculative boom-bust during the past 400 years, and came to one key conclusion which concerns us today. He found that speculative episodes start with something which grabs the financial world's imagination, driving up a single asset’s price or the price of an entire sector. There is high gain positive feedback - success breeds success, and then excess, always atracting new buyers. Speculation then moves towards the terminal phase, where it builds only on itself. The asset, or a whole sector - and today all major equity markets - simply grow without reason or logic.

Investors "jump on board". Those already on board and not only for their own personal benefit, talk up the cant-lose investment, further building the bubble. One interesting aside, all through Galbraith's book, is that financial regulations designed to protect investors were in his opinion almost certainly not able to markedly change a boom-bust phase, or protect investors.

More so than in the 1990s, when Galbraith published this book, the main reason he gave for this apparently pessimistic conclusion is highly valid today. He identified two main categories of actors in "building a bubble", and destroying it. Firstly there are what can be called "permanent optimists" who at all times, even the day preceding the market pop, believe that the run-up is under control and that the market is seamlessly adjusting to a new, higher norm. The new paradigm of value. Today we have dozens of round-the-clock business news media outlets, fulfilling that role.

The second and much smaller group can be called the "eternal manipulators", who are not optimistic but know the market spike is due to time-limited speculation. Their goal is to ride the upward wave of euphoria and get out before it crashes on the rocks of reality. One major unifying factor is that both groups do not have a coherent explanation for why the asset price, the sector or a whole market is "defying gravity". They will resort to a range of fragile explanations which become ever-less credible to any unbiased external observer, as the crash approaches.

The craze of the 1630s, in Holland, was the price of tulips. In the 1980s, and still today but in a more subdued way and diluted among other fragile assets, it was junk-bonds. The Commodities Supercycle, still today and despite the evidence, has stout defenders like Jim Rogers.

In all time, the key requirement for filling pocketbooks and flattering the ego was to get on board early.
As Galbraith notes many times in his book, the role of credit and debt, in a speculative bubble, has been either important or critical ever since the 17th century. As we know, debt itself can become a speculative asset, but the surprise is this asset - notably sovereign debt - has been a driver of massively euphoric market frenzy, followed by total wipeout, as far back as the 1720s. The first example was the French Mississippi Company asset bubble designed to dilute and transfer the sovereign debt of the royal family - a process which needed or caused the total collapse of traded assets, and the closure of the Paris stock exchange for many months.

This brings up another key feature of a "market pop". When a market - rather than an individial asset - crashes this is always with a bang, not a whimper. Financial operators, despite their claims to the contrary are not innovative when it concerns "escape strategies". They will always dump all they can and head for the door - or the window, 1929-style. They are hard-wired to escape quickly. When the actual causes of this dramatic, even kamikaze behaviour are examined and as Galbraith says, we often find almost completely insignificant or symbolic triggers. The information that was available to the market operators, at the time of their sudden change of opinion, was almost never new.

An excellent example is the supposed, now-mythologized role of the Lehman Bros brokerage and private investment banking house collapse in 2008. For mass media of today, the "Lehman crash" was tantamount to being the cause of the huge fall in asset prices across the board and around the world, in 2008-2009.

As Galbraith said when looking at the 1920s financial euphoria which led to the 1929 crash, this bubble spread ever outwards, from the more-credible to the less, to terminate in an across-the-board asset bubble driving up the nominal value of almost all tradable assets. Today in Europe - undergoing what in some countries is the worst ever economic recession they have known - European stocks can climb on a daily basis, driving up the exchange value of the euro currency, boosting commodity prices with it such as industrial metals, raise share prices for heavily troubled carmakers such as PSA Peugeot Citroen, and lift the day traded price of mining shares, retail stores, banks and insurers.

As in the US, the hoped-for maintenance of "quantitative easing" or QE by the European Central Bank, which could or might cut interest rates at its next board meeting, is a recurring euphoria theme. Even the slightest growth of earnings figures reported by major companies, is another precious prop. Industrial and commercial confidence readings - often lower - are brushed aside, for example German business confidence fell for a second month in April, after cold winter weather "hindered recovery" in Europe’s largest economy.

The period following a crash is firstly marked by incredulity that such a thing could happen, then anger against those few clearly identifiable persons in the finance sector who had recently seemed so savvy. The recrimination usually limits to what can be called "primitive introspection', which almost never examines how the speculation of ever-growing asset values was maintained. Reasons for this trace to mass psychology. Because so many people were involved, criticising nearly everybody is akin to identifying oneself as simply a member of a community of fools.

Only under real situations of crisis do we move on to criticism of the "totem" of free-enterprise. Other explanations, and safe scapegoats are always preferred. These are almost obligatorily irrational and, even on the merest hindsight, are unconvincing - for example the role and degree of criminality of Bernie Madoff during the 2008-2009 crisis, like the explanation that Lehman Bros' collapse somehow dragged down world financial markets across the board.

According to Galbraith, investors will only benefit from a speculative boom if they resist two perverse beliefs - the belief that investment success is always intelligently earned, and the belief that what is called "financial opinion" is near-to infallible. This however does not explain why financial euphoria builds to extreme highs in the first place, and becomes a system and process which will only lead to collapse. In the 1990s, when Galbraith wrote his useful book on euphoria, the cult of "financial genius" was almost certainly stronger than today, in other words deference to, and respect of leading figures was higher than today, but their role in driving the euphoria is replaced, and intensified today by factors including market trading systems and technology.

Galbraith could however note that economic history has little or nothing to teach us about market crashes, because of its ambiguity. We only find major recurring themes, notably that financial dementia is always related to the mass psychological impact of "wealth accrual" and its long term historical role of reinforcing belief in onward and upward social progress - which is only transformed into mass disillusion after the inevitable crash. The comforting belief in the intelligence, talent or acuity of market operators bidding up values, whether of land, real estate, equities, commodities, artworks, and even debt has been surely eroded since the 1990s - but residual belief is strong enough for the operators, after a ritual period of discretion, to repeat their movie.

Individuals and institutions are captivated by the wondrous satisfaction of accruing wealth. Since 2008, we can however be less sure that markets are "theologically sacrosanct". Blame of the type that sticks, has been placed not only on the more spectacular or felonious players, like Madoff, but also on "the system" - but still with no coherent explanation of what triggers crashes.

This makes the subject of public anger, following the incredulity, a complex subject. How this public anger should be expressed and acted on is a very amorphous - but most surely emerging and evolving subject.

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2013 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

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