EC Extraordinary Popular Delusions & The Madness Of Crowds

No matter where you look in the market, there are signs of exuberance. As discussed previously, stock market bubbles are about psychology. Throughout history, bubbles are a function of the extraordinary popular delusions and the madness of crowds. 

Of course, that is also the name of Charles Mackay’s book, an early study in crowd psychology. The text, first published by Mackay in 1841, debunked everything from alchemy to economic bubbles. However, the three chapters on economic bubbles received praise from the likes of Michael Lewis and Andrew Tobias.

Essential is the understanding of the role psychology plays in the formation and expansion of financial manias. From the 1711 “South Sea Bubble” to the 2000 “Dot.com crash,” all bubbles formed from a similar “panic” by investors to chase ongoing speculation.

Importantly, in all cases, the speculators involved all thought “this time was different.”

Bullish Psychology

William Bernstein, who updated Mackay’s work, suggests that:

“Bubbles are characterized by extreme predictions, tend to dominate conversations and induce people to leave their jobs. The warnings of bubble skeptics get invariably met with scorn and derision.”

Of course, there is nothing “fundamental” included in that definition. As stated, market bubbles are a function of “psychology,” as investors’ herding behavior drives prices higher. Therefore, price and valuations are only a reflection of that psychology.

“In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you an elementary example of what I mean. The chart below is the long-term valuation of the S&P 500 going back to 1871.”

extraordinary delusions madness crowds, Extraordinary Popular Delusions & The Madness Of Crowds

“Notice that except for only 1929, 2000, and 2007, every other major market crash occurred with valuations at levels LOWER than they are currently.” 

Secondly, all market crashes, which resulted from the preceding bubble, resulted from things unrelated to valuation levels. Those catalysts have ranged from liquidity issues to government actions, monetary policy mistakes, recessions, or inflationary spikes. Those events were the catalyst, or trigger, that started the “reversion in sentiment” by investors.

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Erikas Ivan 3 weeks ago Member's comment

Excellent points here! Indeed, I don't buy the "yeah, but this time is completely different" narrative anymore, and definitely won't be tempted to take chances soon. Learning to take as little risks as possible!

Harry Goldstein 3 weeks ago Member's comment

Agreed, great read.