The Madness of Crowds

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they recover their senses slowly, and one by one.” — Charles Mackay, 1852

We seem to be living in a golden age of “group-think.” Social media and traditional media, the polarization of political discourse, the self-selecting ease with which we can tune out opinions that disagree with our own, and the penchant to view anyone with opposing views as the “enemy” are all contributing to this dangerous phenomenon. This is occurring, of course, when the country needs to muster all its intellectual firepower and collective effort to overcome the near-term challenge of the covid pandemic, and many challenges looming on the horizon. But the prevalence and even encouragement of group-think has fractured society into tribal pods of herd behavior that make solutions all the more elusive. Politically, socially, and financially the madness of crowds is dominating common sense.

This madness was on awful display on January 6th, Insurrection Day, when supporters of Donald Trump stormed the U.S. Capitol. Exhorted to rally in Washington DC in support of Trump’s assertion that the election was rigged and therefore stolen from him, the crowd was whipped into a further frenzy by party leaders and the president (at the time) himself. The resulting assault on Congress will be recorded as a black day in American history, as the mob broke in, smashing windows, assaulting security guards, desecrating the speaker’s podiums and offices, and ultimately causing five deaths.

The constant drip of misinformation about the election galvanized the mob. There was a clear willful blindness to evidence to the contrary—court cases affirmed the results, as did election audits and recounts, and even confirmations of the results in hard-core Republican states such as Georgia.

Dismissing evidence contrary to a crowd’s belief is one key element of herd behavior. Rather than accept uncomfortable facts, crowds tend to ignore them if that is what everyone else is doing. This is a prime example of the well-known behavioral concept known as “social proof.”

Social proof governs how we act in uncertain situations, where the correct answer is ambiguous. In those conditions, we look to the behavior of others as the key to our own behavior. The covid pandemic has provided an encyclopedia of examples of social proof. College parties of many dozens (or hundreds) of students occur because of social proof—once the first partygoers flaunt covid distancing mandates, it opens the doors to others to join as they model their behavior based on what others are doing. The actions of a few individuals can set in motion the actions of many, triggering the tendency to go “mad in herds.”

The foundation of the political world is built on the principles of crowd behavior. While too numerous to cover in this brief newsletter, we want to highlight one example that is becoming problematic, and that is the federal budget deficit.

The Republican party, of course, has long held itself out as the party of fiscal responsibility and advocates of low deficits and balanced budgets. This has all changed over the last half decade, as tax cuts and spending have blown a hole in the deficit, which is now approaching $3 trillion annually. Any pretense of budget responsibility has been thrown out the window and promises to get worse under Biden’s proposed Pandemic Relief Plan III. Social proof is alive and well, sadly, among our political leaders who seem intent to see which party can out-borrow the other. The prevailing attitude seems to be that the U.S. can borrow infinitely with no ill effects.

Of course, the revenue side, taxes, suffers from the same effect. Since no individual is willing to propose raising taxes to fund our borrowing binge, the entire political throng is unwilling to seriously raise this controversial topic. Better to engage in willful blindness regarding the deficit and hope it works out (which it won’t).

Reckless federal spending has been enabled by the champions of group-think, the Federal Reserve. Since 2008, the Fed has engaged in an epic delusion driven by insular group-thinking called “quantitative easing” or QE. QE seeks to not just lower interest rates, but to increase the quantity of cash in the banking system in an effort to spur lending and borrowing.

By reducing interest rates to near zero, and holding them there for the past 12 years, the Fed has enabled Congress’s borrowing spree under the guise of the Treasury’s ability to issue bonds at low yields. Under the mistaken notion that low rates allow the Treasury to ignore the absolute debt burden (federal debt is now equal to 127% of GDP), Congress has been able to dodge the difficult decisions about spending and taxes as they have been able to simply borrow more and paper over any problems. The debt burden has been compounded by the unexpected need for aid brought on by the covid pandemic.

The result is that the Fed is now “monetizing the debt.” This means that rather than pay interest and redemptions (bond maturity) from taxes, they are being paid from money the Fed is printing. Under our “fiat” money system, the central bank can print money without constraint, something not possible under a gold- or silver-backed monetary system. Globally, all central banks operate under a fiat monetary system today.

Historically, debt monetization has had side effects, usually an inflation surge or currency depreciation, or both. Despite growing evidence of inflation however, the Fed refuses to acknowledge its growing presence, seemingly content to believe in “alternative facts.” Notably, inflationary pressures in real estate are clear, with the Federal Housing Finance Agency House Price Index rising 11% in the year to November 2020. Yet this is somehow not reflected in the Fed’s inflation data. It seems the Fed should ask whether their inflation models are flawed, but social proof among its members may be quashing any dissent on this issue.

The most immediate risk of the Fed’s group-thinking is their steadfast refusal to believe their money printing policy does not affect Wall Street and stock prices. One only needs to understand the current fear Wall Streeters have of an end to money printing to realize how deluded the Fed is on this topic. In 2013, for example, the Fed tried to taper their bond purchases in an effort to bring monetary policy back to some sort of pre-2008 normal. Wall Street’s reaction was swift and brutal, as bonds and stocks tumbled, forcing the Fed to back off lest the “Taper Tantrum” be allowed to spiral into a full-blown bear market. Conversely, when an enormous QE program was announced in March of 2020, stocks immediately rallied in the face of the worst economic conditions since the 1930s. Despite ample evidence that QE is now the primary driver of stock prices, group-think at the Fed has precluded them from even considering it a possibility (publicly, anyway).

As a result of this giant QE expansion, we have now evolved into a stock market bubble of epic proportions. This is becoming more evident daily as valuations have now exceeded the 2000 peaks, leverage (i.e., margin debt) has scaled new heights, and removal of central bank liquidity, not poor earnings, appears to be what investors fear most.

But it is measures of investor psychology that we believe cement the case for the existence of a bubble. The behavior of the crowd certainly reminds us of the heady days of 1999-2000, when the internet bubble was in its late stages. Currently, Investors Intelligence’s sentiment survey shows the percentage of bullish advisors above 60% for the ninth week in a row, a very extended period of very high bullishness. Other indicators of market psychology by Morgan Stanley and Bank of America show the psychological environment at not just bullish, but euphoric, levels. Importantly, the euphoria of investors is being taken advantage of by corporate insiders, who are now selling their shares at the greatest rate in 25 years.

Massive insider selling is occurring just as a multitude of individual investors is taking over Wall Street. Day traders have become a revived force on Wall Street (they were prominent at the 2000 bubble peak also). Backed by ample savings, easy-to-use trading apps, and the relentless QE-fueled rise of stocks from the pandemic lows, day traders have exploited ever riskier investing avenues. Not content with NYSE-listed blue-chip names, they have increasingly turned to penny stocks and “call options” to satisfy their gambling instincts. In the month of December 2020, over 1 trillion shares of penny stocks were traded, a record for this speculative group. Call options, a derivative security which is a bet that a stock will rise in price, are seeing record buying levels. Both behaviors are consistent with a euphoric mood, something that only occurs near a price peak.

Nothing, however, exemplifies the current madness of the day trading crowd than the “short squeezes” they have inflicted upon some of the biggest names on Wall Street. By banding together via message boards such as Reddit, legions of amateur traders have coordinated and concentrated their buying of the stocks with the greatest “short” positions among hedge funds, driving prices up. The holder of the short position, facing a theoretically infinite loss, is then forced to buy to “cover” the short position, driving prices even higher.

The results of these “bull raids” by the day traders have been mind boggling with daily gains of 100% commonplace in stocks such as GameStop (video game retailer), AMC Entertainment (movie theatres), and Nokia (cell phones). This is being touted as a struggle between the day trading Davids versus the hedge fund Goliaths, and has taken a nasty turn reminiscent of past mob insurrections. The madness is spreading like wildfire as amateur traders are seeking to both get rich and take revenge on hedge funds.

Today’s extremely bullish mood helps underpin the case that we are in yet another financial bubble. Bubble warnings from some of the largest research firms are being roundly ignored as a sort of mob rule is taking over Wall Street. Both of these are symptomatic of a peak in prices. Experienced investors are taking steps to reduce risk and we are following their lead. Investors should take a step back and reflect on today’s crowd behavior, taking to heart American journalist Walter Lippman’s admonition “Where all think alike, no one thinks very much.”