The extraordinary investor and statesman Bernard Baruch once warned that,
When beggars and shoeshine boys, barbers and beauticians can tell you how to get rich, it is time to remind yourself that there is no more dangerous illusion than the belief that one can get something for nothing.
Over and over and over again, the unwary fall for money-for-nothing illusions — Dutch tulip bulbs, South Sea stocks, Japanese real estate, dot-com stocks, and bitcoin, not to mention baseball cards, beanie babies, and other so-called collectibles.
Now we have a torrent of Reddit chatter inspiring the gullible to gobble up shares of GameStop, AMC, and whatever catches the crowd’s collective attention. Many Reddit-pumped buyers claim that they are part of a noble battle to punish short sellers, but they surely do not think that they are throwing away money. They expect to be rewarded for their communal efforts to drive prices up, up, and away. They have been gripped by what, in retrospect, will be remembered as mass hysteria, yet they are unable to resist the seductive promise of something for nothing.
The pattern-seeking urge we inherited from our distant ancestors often seduces us into extrapolating past movements in stock prices into the future. This is why investors are notoriously late to the party and late to leave, typically buying after prices have gone up and selling after prices have gone down. It might seem that trading algorithms could be a moderating influence since they do not have human emotions like greed and fear. However, algorithms lack not only emotions, but also intelligence. Since algorithms have no idea what any of the data represent, they have no way of judging whether stock prices are reasonable. Instead, mindless algorithms spot momentum in stock prices and magnify the mania.
During speculative bubbles, prices climb higher and higher, beyond all reason, in that nothing justifies the rising prices except the shared belief that they will go higher still. This is called the Greater Fool Theory because it is sustained by the belief that no matter what price you pay, an even greater fool will pay an even higher price to buy it from you. When the bubble bursts, prices collapse because there is no reason to buy something that is otherwise worthless if the price is falling. In the frantic rush to exit the party, very few make it through the door.
Some economists, notably Nobel laureate Vernon Smith, have set up experimental stock markets that reliably exhibit speculative booms and crashes. In one experiment, the participants were given stock and money and allowed to trade with each other via computer for 15 “days.” Each trading day lasts less than 5 minutes and ends with the stock paying a dividend. All the traders know that each dividend is determined randomly, with an average value of $1. Someone who buys on the first trading day can expect to receive $15 from holding the stock for 15 days. Every trading day thereafter, the intrinsic value drops because there are fewer dividends to be received. Nonetheless, the market price typically rises to near $25 a share before plummeting: “We find that inexperienced traders never trade consistently near fundamental value, and most commonly generate a boom followed by a crash in stock prices.”
After a few booms and crashes, traders learn to keep market prices closer to intrinsic value. This learning from sad experience offers little hope for the real world because markets are continually absorbing an influx of new traders who haven’t yet experienced bubbles and crashes.
During Tulipmania in the 1630s, the tulip market in Holland was dominated by trading in taverns among nonprofessionals without cash or bulbs. Some agreed to pay prices they could not afford, anticipating that they would resell the bulb for a profit before delivery. Others traded livestock and mortgaged their houses to buy bulbs.
A bulb that might have fetched $40 (in today’s dollars) in the summer of 1636 traded for $320 in January and $4,000 a few weeks later. The prices of exotic bulbs topped $150,000 and one nobleman was reported to have paid more than two million dollars for an especially rare bulb. In February 1637, the market crashed virtually overnight. As people rushed to sell, buyers vanished and prices collapsed because no one wanted to buy tulips today if prices would be lower tomorrow.
In 1720, the British government gave the South Sea Company exclusive trading privileges with Spain’s American colonies. The company’s directors had never been to America and had no concrete trading plans. Nonetheless, citizens rushed to invest in this exotic venture. As the price of the South Sea Company’s stock soared from £120 on January 28 to £400 on May 19, £800 on June 4, and £1,000 on June 22, some became rich and thousands rushed to join their ranks. It was said that you could buy stock as you entered Garraway’s coffeehouse and sell it for a profit on the way out.
Conmen were soon offering stock in ever more grandiose schemes and were deluged by frantic investors not wanting to be left out. It scarcely mattered what the scheme was. One was formed “for carrying on an undertaking of great advantage, but nobody is to know what it is.” The shares were priced at £100 each, with a promised annual return of £100. After selling all of the stock within five hours, the promoter left England and never returned. Yet another stock offer was for the “nitvender” or selling of nothing. Yet, nitwits bought nitvenders.
Most believed that prices would continue to rise, at least until they could sell to the next fool in line. In the spring of 1720, Sir Isaac Newton said, “I can calculate the motions of the heavenly bodies, but not the madness of people,” and sold his South Sea shares for a £7,000 profit. But later that year, he bought shares again, just before the bubble burst, and lost £20,000. After James Milner, a member of the British Parliament, was bankrupted by the South Sea Bubble, he explained that, “I said, indeed, that ruin must soon come upon us but … it came two months sooner than I expected.”
During Japan’s real estate bubble, the market value of Japan’s land was five times the value of all U.S. land and one-and-a-half times the market value of all land outside Japan. Sounding very much like the Greater Fool Theory, the Wall Street Journal explained that there was little relationship between real estate rents and prices because “land investors count on capital gains, not rental income, to make a profit.” Five years later, Japanese land prices were 50 to 80 percent below their peaks.
In the 1990s, when computers and cell phones were just starting to take over our lives, hundreds of Internet-based companies, popularly known as dot-coms, were launched. Some dot-coms had good ideas and have become successful companies. Most did not. In too many cases, the idea was simply to start a company with a dot-com in the name, sell it to someone else, and walk away with pockets full of cash. One study found that companies that did nothing more than add .com to their names more than doubled the price of their stock. Money for nothing!
Most dot-com companies had no profits. So, wishful investors thought up new metrics for the so-called New Economy to justify ever higher stock prices. One measure of traffic was eye-balls, the number of people who visited a page; another was the number of people who stayed for at least three minutes. Even more fanciful was hits, a web page’s request for files from a server. Dot-com companies put dozens of images on a page, and counted each image loaded from the server as a hit. Incredibly, investors thought this meant something important.
In March 2000, the Wall Street Journal ran a front-page story that reminded me of Bernard Baruch’s comment about barbers and beauticians. At Bill’s Barber Shop in Dennis, Massachusetts — a shop I’ve been to — the locals talked about dot-com stocks while they watched stock prices dance on television. One regular said, “You get three or four times in your life to make serious bucks. If you miss this one, you’re crazy.”
After the dot-com bubble popped, the Wall Street Journal made another visit to Bill’s Barber Shop. Bill was now 63 years old and his retirement portfolio had been decimated. His $834,000 was down to $103,000, which was $50,000 less than he had invested to begin with: “It means that I’m looking at another 10 years of work, instead of being retired.” Bill had given up playing the stock market. Now, he was playing blackjack and poker at a Connecticut casino: “I do better there than I do in the market.” Which isn’t saying much. Sort of like being the world’s tallest midget.
This Reddit-fueled bubble is another nail in the coffin of the efficient-market hypothesis that the stock market always sets the correct prices, the prices that an all-knowing God would set. Like all bubbles, it will end badly, and short-sellers won’t be the only ones who get burned.