Extraordinary Popular Delusions and the Madness of Crowds
In 1841, a Scottish gentleman, Charles MacKay, wrote about wildly exuberant markets in a short treatise by the above title. It became an investment classic. For 180 years, the theme has repeated itself, giving rise to a timelessness in the underlying observation.
MacKay describes how in strong bull markets, people tend to lose sight of reality and pay irrational amounts of money in the hope of chasing down more.
In the last week, we saw that happening again in the US stock market. That madness centered on five stocks, one of which was called GameStop, a provider of video games in shopping malls through lease arrangements from manufacturers. In the socially distanced world of Covid 19, one cannot expect such a business model to make a lot of money. The traffic has disappeared. Professional investors, especially two hedge funds, shorted the stock expecting the company to go bankrupt and the stock price to zero. Seems reasonable enough.
What followed has be described as an uprising of the small investor, a revolution of the unrepresented voice in finance, and a democratization of money. A trading war between amateurs and Wall Street pros. Nerds vs the pin-stripes. To me, it is none of these. I call it the madness of crowds.
The story is entwined into a new phenomenon of retail traders who became active in the markets since they got stuck at home under Covid 19 social distancing rules and Work From Home habits.
With the millions of people stuck at home since 2020 began, with time and money to spare, new brokerage services based on internet connectivity, especially one called Robinhood, offered free trading to retail traders. The circumstances led to an explosive growth of retail trading. And given the obvious bull market, lots of these traders made good money. And they went to social media to crow about it, reinforcing the intentions of the greedy and the bored to pursue dreams of great wealth. Up to now, it has worked.
Couple this with the same social forces that pulled rioters and demonstrators together in vast networks via the internet using services like Reddit forums and other message boards, these traders exchanged war stories, memes, tales of instant success and eventually they pulled together resources to buy. They also sought out the champions among the day traders, who have indeed been remarkably successful. This is a new found social phenomenon. Where in political movements, people were able to quickly communicate to gather in force for demonstrations (and anti-government riots in countries from Lebanon, Chile, Iraq, HK and most recently the US itself), now stock speculators are able to identify stocks to manipulate and the leaders to promote them. The power of a few traders has been transformed into horde-like behavior, and they now hunt like wolf packs, concentrating on larger targets with greater ease.
There are several enabling factors. One is that the underlying conditions of the stock market have been favourable. With economic policy trying to engender an economic recovery, interest rates are at record lows. There is plenty of free money around, made available as margin loans by brokerages. Besides struggling businesses and home owners with mortgages, stock traders have also benefitted from this torrent of cheap money. With institutional money piling into the stock markets as well and the lack of alternate investment channels, equities are enjoying an unrelenting bull market. Given this backdrop, Reddit connected retail speculators who banded together into cohorts of robber barons. It is actually nothing more than the traditional rumor mill amplified by the power of super efficient social media. Tipsters in the old days passed ideas to others one at a time; now they can talk to thousands in the same instance. This accumulates fire power.
The weapon these speculators used to execute their ideas is the options contract. An options contract, actually a call option, is a highly leveraged instrument, enabling a buyer to use a small down-payment to own the right to buy into the actual stock at a contracted price at some time in the future. Professionals sell these products, but these folks would hedge their short options positions by buying the underlying stock. If enough speculators get the stock price moving, then the stock rise becomes entrenched. When that happens, the movement becomes exponential, because each step of an option price increase becomes a larger percentage of the underlying stock. In other words, as the option price rises, the professional option seller needs to buy more of the stock to cover his risk. Once the Reddit crowd finds a suitable target that has all the features of a "pump and dump" stock, the option play will exaggerate the upswing.
Add to this the fact that some stocks have been attacked on the other side by speculators who believe that they are overvalued. American stock markets allow short selling, calling it "free markets" to allow the public to act on activist views that the managements of such companies are fooling investors. Short sellers, when wrong, have the tendency to scramble to cover their losing positions, because in long side plays, traders can only lose as much as the stock going to zero. On the other hand, shorts can potentially lose an infinite amount of money if the stock keeps going up.
What do we now have? The story has now become the battle between two groups of people who want to exercise their "democratic rights in free markets". One is the right to sell short, and these tend to be professional hedge funds who do significant research on the companies' background to conclude that the stocks are not as valuable as what their managements want the public to believe them to be.
On the other side is the group of retail traders who want to take on the professionals and basically crowd them out, forcing them to bail on their short positions and cover. Both groups are highly leveraged. If both groups have complete freedom of action, then we basically have manipulated markets, the bane of regulators.
The regulators have been dragged into the fray because they wanted to ensure a smooth "level playing field". The philosophical question is, level playing field for the longs or for the shorts?
In the GameStop play, two large hedge funds who were short have been squeezed and lost billions. The Reddit "WallStreetBets" army won the tussle and started to boast that they have triumphed over evil professional traders or at least the "establishment".
Here are three Wall Street Journal articles on WallStreetBets:
What to Know About the Week in Markets
Keith Gill Drove the GameStop Reddit Mania. He Talked to the Journal.
GameStop Is a Bubble in Its Purest Form
The surreal thing is that this has been compared to Occupy Wall Street or the insurrection of the Capitol on Jan 6. People power, summoned over the internet, have dealt a crushing blow on the financial establishment. Is this true? Nah. First of all, the battle is far from over. Because it is essentially a centuries-old "pump and dump scheme" with the manipulators being small-timers who used to be on the other side but now acting in concert, the outcome must end with the prices of the manipulated stocks coming down. If the stock does not have the earnings to sustain it, it does not matter who is pushing it up. Whether it is the evil financiers, the corrupt management or these new internet heroes, it does not matter. If the fundamentals are not there, it is an artificial price. That fake price will be crushed, first by the people who jump ship before the crowd does, leading to an avalanche of followers who will then rush for the small swarmed exits in a burning theater. People will get hurt. And you can bet that some of the Reddit crowd are already waiting to cash in their profits. New short sellers will then join the fray. Everybody will ultimately panic. It may take a few rounds of a bruising battle, but there is only one way it will end. This is unfortunately not a new phenomenon. It is a same old same old "pump and dump" operation, motivated by the same greed and fear. And at the end of it all, somebody will be left holding the stock at an unsustainable price. It will likely be the less swift-footed of the Reddit army. With a mob, there is, by definition, people at the front and people at the back. And the ones at the back will be left carrying the can. Delusion can only last so long. Madness will end.
Wai Cheong
Investment Committee
The writer has been in financial services for more than forty years. He graduated with First Class Honours in Economics and Statistics, winning a prize in 1976 for being top student for the whole university in his year. He also holds an MBA with Honors from the University of Chicago. He is a Chartered Financial Analyst.
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