Every bull phase creates a new set of investors who have never witnessed the phenomenon earlier, and who end up believing that the good times will continue until eternity. Then there are also self-doubting market veterans who think, “This time it is different,” thus joining the bandwagon by re-investing their wealth at crazy valuations.
Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay and Confusion de Confusiones by Joseph de la Vega is one of the best books on market psychology. It gives an account of three infamous financial manias — John Law's Mississippi Scheme, the South Sea Bubble, and Tulipomania. The common thread in these is that greed and fear drive the financial markets and are capable of mesmerising even sensible investors.
In the early eighteenth century, stocks were sold in France for the new trade opened up in Mississippi and Louisiana. At the same time in England, stock was sold in trading prospects in South America. The benefits promised fortunes, and people bought up. John Law, an economist as well as a notorious gambler, led the Mississippi Scheme. He was a superb salesmen and the French nobility was completely charmed by him.
This paragraph in the book narrates the scenario in a nutshell: "When fortunes such as these were gained, it is no wonder that Law should have been almost worshipped by the mercurial population. Never was monarch more flattered than he was. All the small poets and littérateurs of the day poured floods of adulation upon him. According to them, he was the saviour of the country, the tutelary divinity of France; wit was in all his words, goodness in all his looks, and wisdom in all his actions. So great a crowd followed his carriage whenever he went abroad, that the regent sent him a troop of horse as his permanent escort to clear the streets before him."
Earlier around the mid-1630s, the Dutch fell in love with tulips and it became a status symbol. Nearly all kinds of citizens such as nobles, farmers, mechanics, sailors, maid-servants, even chimney-sweepers dabbled in tulips. Many converted their property into cash, and invested it in flowers. Houses and lands were offered for sale at ridiculously low prices, or bartered for bargains made at the tulip mart. In smaller towns, where there was no exchange, the principal tavern was usually selected as the “show-place”, where everyone traded in tulips, and confirmed their bargains over sumptuous entertainments. To satisfy the ever increasing demand, speculators began to trade in what were essentially tulip futures; these grew quite complicated and expensive, and finally in February 1637, the tulip market collapsed. Mackay also recounts the story of a sailor who ate a merchant’s tulip bulb, thinking it was an onion. He was jailed!
The second part of the book, Confusion De Confusiones is a set of four dialogues. The first one is about the beginnings of stock exchange in Amsterdam. In the second one, it’s all about the fickle nature of the stock prices and the reasons leading to volatility, common practices and jargons used in the market and the fears in a bear market as against the confidence in a bull market. The third dialogue explains some of the rules of the games and various kinds of transactions. In the fourth one, the author talks about the various traps which could be rumours of war, weather, government policies, shipment news, price of commodities, fake purchase and sales as well as naked short selling.
Much of this madness is still witnessed today in a bull run. It is easy to identify a bubble in hindsight, but if you are in the midst of a developing bubble, it is imperative to spot it before it bursts. Else, you may end up not just losing the profits but the capital too. Our markets may have seemingly the highest levels of safeguards as well as corporate governance and compliance but the basic human nature of “greed and fear” hasn’t changed over centuries and probably will never change. The enterprising ones tend to find ways to subvert the system and the remaining majority toes the line like fools.
In my investing experience spanning over three decades, I have witnessed a number of bull runs. It’s the greed which leads to a bull mania where the underlying story remains the same. A set of people manipulate the narrative, which is then bought by the ever-growing crowd leading to a self-fulfilling prophecy. The subplots change based on the time period and environment, so do the players. After reading the book, if one were to analyse a bit deeper, we will find the same characters even today, albeit sporting a different name. Markets finally converge with fundamentals or the intrinsic value — so beware and don’t get swept up in the “madness”.