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Phew, what a week! The FTSE 100 suffers its biggest single day fall since 9/11, the Fed shocks everyone by slashing US interest rates, and Northern Rock investors find out they may not have lost everything after all. All we need now is for Spurs to have finally stuck one over on the Gooners for the first time in 21 games, to complete a week in which pigs might have actually grown wings.
Of course, it remains hard not to conclude that the bull market has finally given up the ghost, that the sharp sell-off over the past few days signals, once and for all, that the bears are in the ascendant. Already the usual clichés are being bandied about. ‘More room to fall,’ barked the Washington Post, ‘Investors brace for stock crash,’ says the Melbourne Herald Sun in Australia, while ‘Emotions shattered as stock market plunges,’ came reports from India.
Feeling any poorer? Asked one journalist here in the UK of his readers. I hate it when commentators start banging on about how poor we’re all supposed to feel every time the stock market lurches lower, as if our mortgage repayments, gas bills or weekly shopping were somehow attached to the FTSE 100 like a Siamese twin.
Sure, if your car blows its head gasket, or your roof falls in because of the recent downpours, yep, once the bill lands on your doormat with an almighty thump, you’ll feel poorer alright, but not because the FTSE 100 suffered its biggest single-day fall in almost seven years. It’s just one of the habits that scribes have (I’ve done it myself, I’m ashamed to say), once one starts writing it, everyone else seems to follow, a bit like hearing someone repeat one of Bruce Forsyth’s many annoying catchphrases (n’, n’, n’, nice to see you...etc, ugh!), and sure enough, moments later you’re at it yourself (to see you nice...!).
But it is easy to get caught on a wave, find ourselves going with the flow, it’s the herd mentality in us all. Investors especially. Few really like to stand out from the crowd, it’s scary out there alone, and investors want the reassurance that our decisions are good ones because so many others agree. Even the professionals do it.
Robert Shiller, in his book Irrational Exuberance, wrote that 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 the times,’ he calls it, and this spirit transforms thousands of isolated individuals who form the stock market into a mob, a psychological crowd with a conscious personality. Like sheep in a herd, investors find it cozy to be inside the herd rather than outside it. Therefore, most investors right now are on a selling spree.
Someone (I can’t remember where I read this) once compared a bull market with a Ponzi scheme (remember the Enron scandal?), a kind of a 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. The point being that, as word gets out about this amazing money-making formula, so more and more people raid their savings in a desperate attempt to grab their share. No one likes to miss the ‘easy money’ boat. So, as this new cash flows in from newer investors, so their funds are used to pay handsome returns to the initial investors, who end up doing rather well out of it. And so will everyone, as long as the money keeps pouring in in greater quantities than it is being drained out by those old investors.
It seems that bull markets work in a similar way. As Shiller says: ‘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 (stock brokers and mutual fund managers, for example) who benefit from telling stories that suggest that 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.’
What’s more, as markets make ever higher levels, investors tend to look at the recent past pattern and extrapolate this into the future, implying still higher highs. They mistake possibility for certainty.
So, just 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. Yet herein lies the problem, since high prices are not sustainable, as they are driven by unrealistic expectations of further price increases. The tide eventually turns, the situation reverses, the bubble bursts, and prices crash, just as they did on Monday.
However, unlike a Ponzi scheme, when the market corrects, as it has done now, existing investors are not forced to flea the country for fear of 20 years in lock-up. Many readers may at least find this of moderate consolation.