Of bull-charges & the greater fool theory

MUMBAI: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one”  -Charles Mackay

“The crucial thing about the stock markets is that it is primarily driven by perceptions, not performance,” said the late Harshad Mehta in an interview to a magazine in September, 1992. And, perception, as they say, is reality. When perceptions are similar, the stock market moves like a thundering herd, either taking the market soaring up or tearing down.

That more than anything else explains the nearly 800 point jump in the Sensex on Tuesday. Nothing has fundamentally changed with the economy. Nor is corporate profitability expected to go up by leaps and bounds. Yet, in the last one month, the Sensex has gone up by around 20%.

So, why is the stock market going up, as if there is no tomorrow? For an answer, read on. Benjamin Graham and David Dodd, in their all-time classic, Security Analysis, explain the way a stock market works.

“The market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.” Right now, most individuals seem to be voting with their emotional cap on. And why is that happening?

Robert Shiller provides an answer in his book, Irrational Exuberance. “A fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a zeitgeist, a spirit of times,” he writes.

This spirit of the times, transforms the thousands of isolated individuals who form the stock market into a psychological crowd, which displays a conscious personality. At an individual level, stock market investors are very different, but the fact that on a whole they have been transformed into a psychological crowd gives them a collective mind.

This happens as psychologically, the desire to conform to the behaviour and opinions of others, a fundamental human trait, is what drives such buying behaviour. Like sheep in a herd, investors in a bull run find it cosy to be inside the herd rather than outside it. And so every investor is now on a buying spree. The bears have all been squeezed out.

The stock market right now is akin to a Ponzi scheme, which is a kind of financial fraud where an illusion of a successful business is created by using the money brought in by new investors to give handsome returns to the old investors.

As the news about the high returns spreads, more investors rush to invest in the scheme. The money brought in by these new investors is again used to service the returns of the existing investors. In this way, the scheme keeps running as long as the money coming into the scheme is greater than the money leaving the scheme.

The current bull market has become a Ponzi scheme. Stories about the market going up and a certain set of investors doing well have been spreading everywhere. Investors, big and small, in an optimistic mood, want to buy stock and take the stock price further up. This has led to more investors entering the market, fuelling an even greater price rise and repetition of the cycle over and over.

As Shiller mentions, “When prices go up a number of times, investors are rewarded by price movements in these markets, just as they are in Ponzi Schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest the markets will go up further. There is no reason for these stories to be fraudulent; they need only emphasise the positive news and give less emphasis to the negative.”

Now, if you have been following the business media closely, you would know why most analysts remain positive on the market.

Investors themselves have a role to play in all this. “In making judgments about the level of stock prices, the most likely anchor is the most recently remembered price,” says Shiller.

And when the markets have been on their way up, investors tend to look at the recent past pattern and assume that the future patterns will be identical to the past ones and tend to believe that it will keep going up forever. They mistake probability for certainty.

Like in a Ponzi scheme, the stock market keeps going up as long as the money coming in is greater than the money going out. The high prices are not sustainable since they are driven by unrealistic expectations of further price increases. The bubble eventually bursts and prices crash.

As Peter Garber points out in his research paper, ‘Famous First Bubbles’, “Finally, all investors may perfectly understand that the venture has no chance of paying large dividends, but that a sequence of share buyers at ever-increasing prices is available. Investors essentially gamble that they will not be in the last wave of buyers.”

In modern parlance, this is known as the greater fool theory. The investors also gamble because they are ready to accept the large probability of a loss in the hope of a small probability of gain.

That, in short, explains the recent spurt in the prices of most stocks. If you still want to enter the stock market rather than wait for sometime on the sidelines, one must say, you are a brave man.