By Jason Zweig | November 5, 2011
Image Credit: Christophe Vorlet
Can you spot a bubble?
Ever since 1841, when a Scottish journalist named Charles Mackay published the book known today as “Extraordinary Popular Delusions and the Madness of Crowds,” the answer has seemed clear. If you watch carefully for signs of euphoria, you can sidestep the damage when markets go mad.
But bubble spotting isn’t as simple as Mackay made it sound—even, it turns out, for Mackay himself. Investors should always guard against the glib assertions of pundits who claim they can detect bubbles before they burst.
It’s also a reminder that expecting policy makers to predict the future by popping “bubbles in the making” is probably a bad idea.
Although plenty of people claim to have seen bubbles in hindsight, determining when enthusiasm morphs into euphoria is an inexact science at best. Consider today: With the global financial crisis lingering, but initial stock offerings like Groupon buoyant, is the stock market a bubble? When ATMs dispense gold bars, is gold a bubble? When some of the biggest bond investors say they are willing to buy Treasury bills at negative yields that lock in losses, are government securities a bubble?
One of Mackay’s admirers was Bernard Baruch, the famed speculator who survived the crash of 1929. In 1911, a news service reported that Baruch was so struck by the similarity between “the speculative orgies of history” described by Mackay and the contemporary mania over stocks like Union Pacific that he dumped all his railroad stocks right before they fell sharply.
But new research tells the untold tale of Mackay’s own behavior in the face of a bubble—and it is a shocker. A mathematician and former cryptographer at Bell Labs named Andrew Odlyzko has spent much of the past decade researching a forgotten stock mania. One of its biggest boosters was none other than Charles Mackay.
A bubble in British railroad stocks began in 1844, only three years after Mackay published his book, and it didn’t start to collapse until late 1845. Even with the history of market folly fresh in his mind, Mackay urged British investors to pile into railway stocks, whose extravagant prices were based on absurdly unrealistic projections of future growth.
The most famous critic of bubbles who ever lived fell like a chump for a craze that was unfolding before his very eyes. On Oct. 2, 1845, Mackay wrote that “those who sound the alarm of an approaching railway crisis have somewhat exaggerated the danger.”
He went on to ridicule anyone who argued that “the Railway mania of the present day” was similar to the devastating bubbles he had described in his own book. “There is no reason whatever to fear” a crash, he concluded.
He couldn’t have been more wrong. From 1845 to the bottom in 1850, railway stocks fell by two-thirds—the equivalent of roughly $1 trillion of losses in today’s money. Mackay never fessed up to his own extraordinary delusion.
So is it possible to build a reliable bubble detector?
Mr. Odlyzko has proposed a “gullibility index” that would use social media like Twitter to track such factors as innumeracy and diversity of opinions, which could signal that investors are more vulnerable to mania. The index isn’t yet live.
The “Bubble-ometer” at www.marketpsych.com is a rough gauge of speculative fever. A reading over 40 signals possible danger; readings below zero, relative safety. It monitors Twitter and hundreds of websites to track mentions of stock prices and fundamental measures of value like corporate earnings. When price chatter dominates discussions of value, the Bubble-ometer glows hot, as in 2007 and this June; lately it has cooled again, dropping from a reading of 56 to a temperate 16.
The great value investor Benjamin Graham suggested that investors should never have less than 25% or more than 75% of their money in stocks. He argued for reducing the allocation to stocks “when in the judgment of the investor the market level has become dangerously high.” But, because no one can perfectly predict a bubble, you should never go either to zero or 100%.
After all, if identifying bubbles somehow became easy, investors would stop buying before prices got out of hand. So “being right about past bubbles does not automatically ensure that you will be right about the next,” says Robert Shiller, the Yale economist who called both the Internet-stock and real-estate bubbles.
That’s partly because many forecasters fall prey to overconfidence like Mackay’s and partly because the markets are always in flux.
“I’m very skeptical whether anyone can predict bubbles reliably,” says Mr. Odlyzko. “It’s an arms race: Anytime you come up with a bubble detector, people will try to get around it.”
Source: The Wall Street Journal