Market Bubbles

Understanding what makes this financial meltdown so distinctive

In James Surowiecki’s wonderful book The Wisdom of Crowds, he tells a story of Francis Galton, the 19th century mathematician, that perfectly captures what it is that makes stock markets such extraordinarily efficient mechanisms for finding the true value of any company. In the story, Galton attends a country fair, where a contest is underway for all the fair attendees to guess the “dressed down” weight of an ox on display. Galton, an elitist at heart, was particularly curious to know exactly who was able to guess correctly and what their professional background was. Astonishingly, no one individual came particularly close. But…when all the guesses were added up and then divided by the number of respondents, the answer was 1,197 pounds vs. the correct weight of 1,198 pounds!

It took Galton repeated experiments to prove to himself conclusively that “if you put together a big enough and diverse enough group… that group’s decisions over time will be intellectually superior to the isolated individual – no matter how smart or well-informed the individual.” So while human beings are, for the most part “boundedly rational” in that we base decisions on limited information and emotion invariably plays a big role in decision-making, our collective intelligence can be excellent. It is this phenomenon that makes everything from our markets, to our elections, function as effectively as they usually do.

The operative word here is “usually”. Astonishingly, crowds only become wise if their members’ ideas remain independent and uncontaminated by each others’ thinking. Never confuse the wisdom of crowds with a consensus. Once crowds start to form a consensus, this is when things fall apart.

As Per Bak, the theoretical physicist, points out, stock markets exist in a state of self-organised criticality – in other words, they maintain a fine balance between a steady state and complete randomness. Think of a sand castle, where you can drop one grain of sand at a time and the pile just keeps getting bigger and bigger until it reaches a critical point where the next grain of sand unleashes a powerful landslide, pulling all the other grains of sand down with it. His observation: knowing when that fine balance is going to get tipped is almost impossible to predict¹.

Our challenge then, is to try and pinpoint exactly what dynamics transformed the finely balanced wisdom of crowds into a stampede of fools.

Global financial history is littered with any number of market bubbles followed by market blow-outs or “landslides”. Their formations and dissolutions follow highly predictable patterns – up to a point; the most notable description of which is the Kindleberger/Minsky Model², (see flow chart below).

Anatomy of a bubble - Kindleberger/Minsky Model

Whether we’re tracing the path of the South Sea Bubble, the 1920s Equity Bubble, the Dot.com Bubble, or today’s catalyst: the US Housing Bubble and sub-prime crisis, the pattern is clearly recognisable – although never in advance. An opportunity emerges that displaces all others as the preferred opportunity (persistently rising house prices in the US), credit creation facilitates the continued surge in value (Greenspan keeps interest rates low and financial institutions devise credit pick-ups through the creation of instruments that can off-set the risk of low-income housing loans), euphoria kicks in as everyone sees these new instruments as providing an easy way to add value without “risk” or too much research effort, financial distress disrupts this ever-inflating bubble (a rise in interest rates triggers a spate of mortgage defaults and brings asset-rich Lehman Brothers to its knees when it can no longer finance its short term obligations on credit swap instruments) and then, finally, the markets are catapulted into a state of revulsion (as short term liquidity seizes up, anything and everything that can be sold is sold, widespread de-leveraging tips a number of global economies into a recession, and finally we’re all given something to really worry about).

As such, we could easily sit back and reflect that these things are simply a part of the free market reality and they will occur again and again and again simply because that dynamite human combination of fear and greed will always be a part of our natural make-up. Still, the current financial crisis has been the product of some unique but changing cultural phenomena that makes this crisis distinctly different from anything we’ve ever experienced. What follows is an assessment of what went wrong from a slightly different angle than that covered by the financial press: one that assesses not the market mechanisms that failed but focuses more on the changes in human dynamics that unleashed a chain of unintended but inevitable consequences.

We believe that unless one gains a clear insight into how these changing phenomena contributed to the speed and intensity with which the markets lost their equilibrium, we run the very real risk of never quite putting Humpty Dumpty together again. More importantly, understanding the crisis from a broader social context provides some clarity as to what needs to be addressed if we want to ensure that our recovery from the crisis (and yes, there will be a recovery) remains reasonably sustainable.

Two factors have been instrumental in making the sub-prime crisis and subsequent financial meltdown distinctively different: the Internet and the changing social fabric vis-a-vis money and what it means in our lives.

“The first disaster of the Internet age”³

One can look at the unique role that the Internet played in the global financial meltdown from three distinctly different levels: an information-dissemination level, a psychological/sociological level and a consensus-building level.

As Paul Kedrosky pointed out in Newsweek magazine “ Allan Greenspan lit the fuse of the credit crisis when he extolled the revolutionary virtues of the ‘Net in 2005 - and redefined risk and responsibility”. So, from this perspective one can appreciate the integral role the Internet played in terms of:

• Disseminating technical know-how.
  Without the Internet, the technical know-how on how to structure many of these exotic instruments that repackaged and reinsured credit risk would never have been so widespread or so readily accessible. The rapid dissemination of creative new ideas became easy, but without any understanding of the long term impact or risks embedded in these new ideas.
• Creating a means to distribute financial instruments globally – and almost instantaneously.
  With traders now able to text message $100 million deals with no regulatory muss or fuss, a $1 trillion shadow banking system was created to market credit default swaps electronically – undocumented and little understood. Over half the “toxic assets” created to finance sub-prime debt were subsequently sold outside of the US.

But the speed and convenience of the Internet age is a double-edged sword: we should not ignore the psychological and sociological impact this bombardment of information has on investors.

• It enveloped us in the consoling illusion that we all knew everything when we only knew a very small part of the whole.
  Any number of investment professionals have argued that anyone with access to Google and a computer would have had all the information required to understand everything about the true situation vis-a-vis sub-prime investments and its precarious nature. A Google search of the ‘Net validates this point. It’s just that the information was disseminated in a million unconnected pieces leaving you, the uninitiated investor, with the task of connecting all the dots.
• Investors were bludgeoned into indifference through the data smog of free information.
  The behavioural finance specialists point out that when human beings are inundated with information, their immediate response is to shut down, effectively reaching a state of paralysis. When forced out of immobility, their next immediate response is to simply do what everyone else is doing, on the grounds that “a million other investors can’t be wrong”. It is only one small step from this herd-mentality mindset to the tipping point of consensus-thinking that disrupts delicate market equilibrium and precipitates a stampede of fools.
• The Internet and other collateral instantaneous communication capabilities ensured a total lack of accountability between the trading participants and the reality of their underlying clients.
  With instant text messaging now the new norm for conducting mega million dollar transactions, it is little wonder that traders began to think of global trading as little more than a large scale video game. Slip up on the execution or the follow-through and you can just press the reset button.

Finally, comes the role the Internet played in tipping the market’s finely balanced information equilibrium. In Robert Shiller’s recently published book The Sub-Prime Solution he makes the following key observation. An “information cascade”, occurs because “those in the group disregard their own individually collected information because they feel (once again) that everyone else couldn’t be wrong.” In essence, the quality of group information deteriorates irrevocably as the crowd’s wisdom is overturned by an erroneous consensus.

This time around, the “information cascade” would not only do so at unprecedented speeds, but it would leave no corner of the globe untouched.

• By speeding up the rate at which the “grains of sand were dropped” onto the market - the market psychology increasingly overshadowed economic reality in terms of dictating market movements.
  Market meltdowns or surges that used to unfold over the course of multiple years now take place almost instantaneously, thanks to the speed at which the herd can be communicated to 24 hours a day. As Jonathan Davis of the Financial Times points out: the “Mr Market” of Benjamin Graham’s days not only no longer sleeps, his perambulations are no longer restricted to the US markets and, even more confusing, he has spawned any number of relatives in new and exotic instruments that no one in Graham’s time could have dreamed of.

So, in summary, while the Internet in many ways revolutionised the way we invest, the speed at which we can invest and the wealth of information at everyone’s fingertips for investing; it also contained the seeds of our own potential financial Armageddon.

That said, the Internet, as technology, may be fashioned to either enhance or obfuscate important investment insights. The trick is to ensure a more effective means of filtering and aggregating information, to say nothing about forcing the shadow banking industry and its traders’ transactions into the light of day. While these enhancements to reducing the “noise” ratios to information disseminated on the Internet are emerging rapidly, we simply hadn’t reached an adequate level at the time of the meltdown.

The tectonic shift in our social fabric

While the Internet provided the more immediate facilitating mechanism for changing the rate at which markets react, a more subtle but farther-reaching factor was changing the way we human beings interacted with one another in the market place.

Three interweaving elements have been instrumental in this change: the gradual shift in work focus to simply “making money for money’s sake”, the increasing commercialisation of professional services, and the shift in control of investment assets and investment decisions from principals to agents.

In the classic 1905 economic treatise The Protestant Ethic and the Spirit of Capitalism, Max Weber provides a compelling argument that capitalism as it emerged in 19th century America and Europe was a direct by-product of a shifting religious view that saw the work ethic as a critical factor for determining “one’s favour in the eyes of God” According to the newly emerging Protestant religions, an individual was religiously compelled to follow a secular vocation with as much zeal as possible. An ancillary to this entreaty though, was that money earned through hard work should not be wasted on luxuries or frivolities, but rather “re-invested” in the further growth of production for the benefit of the broader community. From the beginning of our nation's history, with the Puritan and Protestant work ethics, through to the 1950s, thrift was considered an important virtue, both with regard to the moral fiber of the country and as a support for its continuing economic wellbeing.

While the rise of capitalism is a function of a myriad of complex factors that go far beyond this simple explanation, Weber’s thesis at least helped crystallise thinking as to how men found meaning with their lives. Well into the early 1900s, the dominant view in the Western world was that productive souls built and created for the better of mankind - as well as their own pocketbooks. As such, a career on Wall Street or in the fledging stock-broking firms of Europe ranked about as low on the professional prestige list as was possible. Respectable souls did not engage in either usury or the business of simply making money for money’s sake.

But as Robert Shiller points out in The Sub-Prime Solution, at some point towards the beginning of the 1960s, this attitude began to quietly morph. By the early 80s, Wall Street was beginning to lay on rich rewards to attract the best and the brightest to the business of making money with money. Young, highly educated talent were given extraordinary responsibilities – not because they necessarily understood what they were doing or why, (read Michael Lewis’s Liar’s Poker or his latest piece ominously titled The End to understand just how extraordinary this phenomenon was) but because, being smart, they were deemed to possess the skills to trade their investment bank’s book into great fortunes. Soon, notions of “mover and shaker” or “smart money” no longer applied to the industrialists of the day but rather to those astute individuals who knew how to make money by simply being able to turn some money into more money.

Why should we care at all about this transformation? Effectively, as the behavioural economist Dan Ariely points out, the more removed an individual becomes from the reality of what those investment monies mean, who those assets really belong to, and what the gain or loss of those assets may really mean to the broader economy, the less likely the agent of investment is to properly derive insights into their true riskiness. Effectively, for the “professional” entrusted with this critical fiduciary responsibility, this level of disconnect has the potential for disastrous failures in oversight or prudence.

Couple this shift in mindset with the rising phenomenon that professionals across the broad spectrum of services – lawyers, doctors, consultants, and of course, fund managers – were being increasingly pressured over the same timeframe to “commercialise” their service offering, and the stage is now set for all manner of conflicts of interest between “professional” service provider and their own clients.

This inevitably engenders a culture in which business, needing economies of scale in order to remain profitable ignores the individual needs of its clients in favour of cookie-cutter solutions.

Today, nearly 90% (and possibly higher) of all transactions in the markets have some form of agency intermediation – whether it be by the trader acting on behalf of the investment bank, the fund manager acting on behalf of the unit trust investors or pension fund investors, the stockbroker executing trades for individual investors or day-traders, or the analyst making recommendations to the broader public. With every step distancing the investor from the trade comes an increasing risk that markets will continue to be driven by herd mentality and less by fundamental economic logic. Consider this simple point made by Georges de Nemeskeri-Kiss and Yannick Maleverne of Emylon Business School: If most decisions in modern financial markets are taken by agents and not principals, and agents continue to be evaluated and rewarded on the basis of short term performance relative to their peers, it clearly will be safest for them to stick with the herd.

Unfortunately for our markets, as we know from The Wisdom of Crowds, the more herd-like the market becomes, the poorer the quality of decision made by the total sum of its participants. Worse, the herd instinct cannot be regulated by law. As such, it will persist with each subsequent market crisis, unless one tackles the immediate agency conflict that lies at the heart of this changed dynamic.

Unfortunately for our markets, as we know from The Wisdom of Crowds, the more herd-like the market becomes, the poorer the quality of decision made by the total sum of its participants. Worse, the herd instinct cannot be regulated by law. As such, it will persist with each subsequent market crisis, unless one tackles the immediate agency conflict that lies at the heart of this changed dynamic.

Of all the publications that have accompanied the recent financial crisis, perhaps the most thoughtful and thought-provoking is Robert Shiller’s The Sub-Prime Crisis. Shiller argues that things have the potential to get so bad that “we eventually put aside political and policy differences and fall back on a more social contract – one that dictates that we as a society will protect everyone from misfortune and keep existing problems from spreading.” ⁶

Perhaps the election of Obama Hussein Barack on 20 January this year provides as clear an indication as any that this point was at least reached by America’s citizens. This time, unhampered by manipulations from the sidelines, the American public actually did make an astonishing decision as a collective that no one who understood the individual participants could have ever anticipated.

So, if Americans are going to put aside bi-partisan politics and maintain this collaborative social contract in meeting the current challenge of the financial crisis, bottom line: any bailouts applied cannot be directed at simply maintaining high asset class prices. Rather, the focus must be to prevent distress among people of modest means. If we can stick to this agenda there may well be hope.

Shiller is unequivocal on this point: that these phenomena will repeat themselves and at increasing regularity unless we shift our focus to democratising finance. This provides us with our best shot at countering the current endemic agency/principle conflicts.

What that effectively means is ensuring that advice, information and access are as widely available to the broadest classes of savers and investors – not just the wealthy or professional.

It suggests, for one thing, that Paul Kedorsky was on the right track in his plea for the broader community to demand that the Internet be refined into a far more meaningful aggregator of information, with filters to sift out the more reliable, quality information at all levels.

But it also demands a return to sanity in terms of how investment professionals are rewarded and to what quantum.⁷ John Bogle has eloquently argued that individual investors put up 100% of the capital, take 100% of the risk and share in as little as 30% of the takings – if there are any. But investment intermediaries get away with putting up none of the capital, take none of the risk, and walk away with a handsome compensation – win or lose. Extraordinarily enough, the industry has for some time had very clear insights as to approximately how much alpha or benchmark outperformance a top active manager could potentially generate over the long term – and yet still it believes it can charge investors, in total, in excess of this quantum, and the investor will be none the wiser.

Clearly one subtle message, then, that is coming through the turmoil is that investors cannot completely abdicate responsibility for their investment to so-called professional agents. Rather, they need to be assisted in developing strong oversight mechanisms that provide insights and guidance as to how these investments could be most effectively managed. This is where government, the regulators and the professional associations such as the CFA (Chartered Financial Analyst) Institute can play a critical role.

In truth, if anything is going to re-establish equilibrium to the agent/principle dynamic, push us beyond the current herd mentality of the markets, and restore wisdom through its collective individuality of purpose and thought, it must surely be that investment professionals need to demonstrate their professionalism by acknowledging their fortunes and reputations are inextricably linked with their clients’ successes, and not simply the financial success of the financial institution and its shareholders.