Odd Lots - This Is What All Great Stock Market Bubbles And Crashes Have in Common

Episode Date: August 28, 2017

Markets are at their most exciting when they're in a bubble. Spectacular fortunes can be made and lost in the blink of an eye. So how do bubbles form and end? On this week's episode of the Odd Lots podcast we talk to Scott Nations, the president and chief investment officer of NationsShares, and the author of "A History of The United States in Five Crashes." We discuss with him various stock market crashes and bubbles in U.S history, and what they all have in common.See omnystudio.com/listener for privacy information.

The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Rafini. We'll bring you the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off.

And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's, events into context, examining what happened in the markets and the world. That on Sundays we speak with journalists, columnists, and key political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plans take you. Watch us on Bloomberg Television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend.

Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. Hello and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway. And I'm Joe Wisenthal. Joe, I am very, very excited about this episode because we are about to embark on our second series here at Odd Lots. Our first series was about financial crime and financial shenanigans, right?

Yeah, it was great. You must remember it. It wasn't that long ago. No, no, no, no, no. I'm playing dumb, but I do remember it. It was very fun. And I'm excited about our new series. Yeah.

So in our grand tradition, I guess, of dealing in the worst of human character, we are going to be all about fear and greed in our next series. We're going to be talking about bubbles. This is going to be great. I'm really excited. Let's just be honest. Bubbles are when markets are at the most fun. I mean, there may be markets at their worst,

but when markets are just trading on pure. emotion, fear and greed, totally divorced from fundamentals, panic, everyone wanting to get rich. It's hard to argue that that isn't when markets are at their most interesting. No, I totally agree. And you hit the nail on the head because if you think markets are a reflection of human emotions and human nature, then the extremes are probably the most interesting facets of that. And I mean, I have to say the other thing about bubbles, and I think the real reason that everyone is always perpetually fascinated with them is that you can get rich during a bubble if you can time it perfectly, right? And who doesn't want to get rich? So what bubble

are we starting with today? All right. We're going to start out with the quintessential bubble, in my opinion. And that has to be the sort of 1920s stock bubble and the subsequent crash. And we're also going to be discussing some other stock market bubbles that happen along the way, including, of course, 1987, and we might even get to 2007, 2008. I can't wait. I mean, obviously, there's bubbles in many things. We've had some episodes, in fact, about bubbles, including Beanie Babies and Catfish and probably some others. But I do think that when people think bubble, they probably first think stock market bubbles. So I think, you know, there's sort of some of the history of the big ones in the United States is a great way to start. We're starting out very, very classical.

All right. So here with us to talk about various stock bubbles is Scott Nations. He is the author of a book called A History of the United States in Five Crashes, Stock Market Meltdowns, that defined a nation. I actually know him from his other job, which is president of nation's shares. It's a company that's been building a lot of indexes, including some interesting. volatility indexes. So we might even ask them about those later in the show as well. Scott, thanks so much for coming on. It's great to be here. So, Scott, you know, your book, I think, is probably the perfect one for us to begin this series. But just to set the scene for us, I want to start with the 1929 crash. If you could pinpoint one thing that sort of sparked the

euphoria that led to that initial 1920s stock bubble. What would it be? It would have to be a friendship. And I know that sounds goofy, but it was a friendship between the head of the Federal Reserve Bank in New York and the governor of the Bank of England. And these two wonderful guys, Montague Norman and Benjamin Strong had a wonderful friendship and they were trying to help each other. And in doing so, Benjamin Strong kept interest rates in the United States ridiculously low. It's not the first time the Fed has done that, but he kept interest rates in the United States ridiculously low, even lower than they had been during the emergency level of World War 1. And that is really what fed the bubble that became the 1920s and then ultimately the 1929 crash.

And it's easy to think about these crashes in numbers, but they're dramas. Each of them is a drama. Each one of them is a fascinating drama. And in 1929, it's a little bit like the story of the Titanic. We know how it ends, and it ends badly. But it's a fascinating story. I don't want to skip ahead to another bubble, so I'm not going to. But when I've read about the 1920s, something that struck me was analogies to the late 90s bubble. Because in addition to the good financial conditions you characterized, there were a lot of genuinely,

genuine reasons to be excited about things. It was peace. There was the increasing widespreadness of the automobile, the radio, this new communications technology was taking off. But there was just all kinds of non-financial reasons for people to start to get excited. Absolutely. All of Europe had been devastated by World War I. The American industrial base had been untouched. People were buying automobiles, there was another invention, relatively new invention that everybody had to have. It was the radio, RCA, Radio Corporation of America, started the decade as a $2 stock, and after splits, it ended the decade, well, almost into the decade, at about $570. So you're absolutely right. Everybody felt great about America and America's place in the world. Interest rates were low. The Treasury had also made the country, a country of investors, by

selling them war bonds, and that that bled into them buying stocks once the war was over. So you have this mix of low interest rates, relatively positive economic growth, a lot of optimism about the future, a fairly steady geopolitical landscape. When did the wheels start to come off? And what were the signs that trouble was potentially ahead? Unfortunately, in 1929, we really didn't get any clues until very very, very, very late in the game. There were certainly some people that were worried, but it wasn't really until September of 1929 that people started to worry and talk about their worry out loud. The striking thing about each of the five crashes that I talk about is that each has a catalyst that has very

little to do, often very little or nothing to do with finance. In 1929, it had a little to do with finance. There was a fraudster in London by the name of Clarence Hattry who simply started counterfeiting stock certificates. And in a day when everything was on paper, he managed to completely undermine the stock market. And he wasn't found out until September of 1929. And that's when the wheels tracing your in your phrase really started coming off. One thing I like about crashes is it really is, I think, impossible to pinpoint what caused the crash, because you can point to a million things. I know one of the, it's so minor, but I think one of the things people point to was some regulator in Massachusetts preventing a utility company stock from splitting. The most minor

thing in the world, but it freaked out utility investors pointing to if this one minor regulatory body in Massachusetts can freak out investors, how fragile the whole edifice becomes. You make a great point. Until then, this financial regulator had allowed any utility that wanted to split its stock. They had allowed them to do so. They were essentially a rubber stamp. But then a utility in Massachusetts came to home and said, we'd like to split our stock four for one. Their reason was because it's the fashion of the day. No more reason than that. It's the fashion of the day. And finally, the regulator had had enough. And they said, nope, your stock is already. trading much higher than any intrinsic value. If we allow you to split it, it will get even worse. And this is our line in the sand. It was finally somebody who had said, somebody in authority who had said, this is not right and this needs to stop. I love the idea that maybe a regulator in Massachusetts

of utility companies could possibly be responsible for the stock market crash and the subsequent Great Depression. Well, they certainly helped. They certainly help things on their way. Okay, so you get these sort of idiosyncratic things happening and people start to get a little bit nervous and stalks. I guess they really start coming down on Black Tuesday, right? I always get it mixed up with Black Thursday, but Black Tuesday was the first big drop. Is that right? Well, there were two nearly identical drops, the 28th and the 29th. It actually started just after Labor Day.

That was the day after Labor Day was the peak of. the market. But you're right, the 28th and 29th of October, when the market, both of those days, the market was down about 12 and a half or 13 percent. That's when it really, really, really got bad. So how do people, how were people reacting in that time period? Because whenever we see stocks drop nowadays, you know, we always get the chorus of people talking about how this is a healthy correction to use the cliche. I wonder if the same thing happened in 19. I don't think people understood. Well, certainly people didn't recognize what the 1930s were going to look like, and there's no way they could have. I think what they were doing was they were looking back to what had happened in 1907. The panic of 1907 is the first crash I talk about. And that was a panic. And each of the crashes have heroes and villains. The hero in 1907 was undeniably J.P. Morgan. And I mean, the man, not the bank, because he nearly single-handedly stopped the crash. Well, in 1929, there were a bunch of financiers who thought that they could be the modern day J.P. Morgan. And they tried to do that.

They tried to step in, raise some capital, buy some stocks. And so I think that for most of October of 1929, I think most people thought this is bad, but it will stop and then we'll go back up. And it will be like every other break that we've had in the market. They didn't realize that they were going to end up making things worse and that it was going to get as bad as it did. I feel like we could actually probably just do the whole episode on 1929 because it's so rich, and we should move on soon. One other right nugget I really like from it, I remember during the 2008 crash, you know, there was that famous Warren Buffett op-ed in the New York Times, I think. He's like, buy stocks, I know I am. And there was something similar. John Rockefeller did a similar thing. He was sort of came out of seclusion. He's like, I'm buying American shares. It's a good deal. Like all these

attempts by the sort of business legends to just instill confidence with their words alone. Well, John D. Rockefeller in 1929 said, my son and I are buying stocks. And he, at the time, he mentioned some outlandish number he had spent a number that only JPE, that Rockefeller could spend. But for the most part, people weren't really afraid in a way that Rockefeller could could calm. I mean, they were, they ultimately were really afraid. They were afraid that they were going to lose everything. Yeah. And it's funny. We still see that happening, I mean, all the way up to 2008 when Warren Buffett came in and invested in Goldman Sachs shares right in the middle of the banking crisis. I'm Francie Lacquois, an award-winning journalist. And I've got a new podcast,

leaders with Francine Lacqua from Bloomberg Podcasts. I've interviewed everyone from heads of state to fashion icons about the news of the moment. But I've always been curious, who are these people as leaders? I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision. Listen to new episodes every other Monday. Follow leaders with Francine Lacroix wherever you get your podcasts.

I have a feeling that Joe wants to move on to a later stock market bubble and crash, and that would be the events of 1980s. That sounds good. Let's talk about 1987. You know, it's interesting because we hear so much about quants these days and people are sort of nervous that the quant machine are going to malfunction and we're going to get this wave of uncontrollable selling from computers and everything's going to melt down. 1987 was kind of a precursor to these fears. It's interesting. The five crashes that I discussed pan more. They, they see. span more than a century. But each one is abetted by some sort of, I call them financial contraption that is new, it's novel, it's poorly understood, and it's untested under stress. And in 1987, probably the prototypical contraption was portfolio insurance. It seemed like

an ingenious invention by a couple of academics at Cal Berkeley. And it was a way they expressed it is a way for investors, institutional investors, to make certain that their stock portfolio never fell below a certain value. It required regular, regimented selling of stocks as they fell. The problem is that we know now, we should have known then, that when we demand liquidity is when it evaporates. And that's what happened. It was the typical, prototypical, really financial contraption. The interesting thing is that in the worst, of the crash of 1987. The guys that had created this, Leland, O'Brien, and Rubinstein, were running a business that

would sell futures to affect this insurance. And their trader at one point on October 19, 1987, refused to sell any more futures. His quote was, if I sell all the futures that I'm supposed to, I'm certain I will drive the market to zero. Wow. So did he save the world? Well, I'm not certain he saved the world, but he helped stop the bleeding. If somebody saved the world, it might have been Alan Greenspan the next morning with a wonderfully terse comment that consistent with its position is the central bank, the Fed is ready to essentially give anybody anything they want.

And then the Federal Reserve got on the line with banks and said, we'll give you anything you want. Now, I'm worried we're cheating a little bit here because we talked about the crash of 1987, but this is the bubble series. Was there exuberance? What was the pre-October 87 vibe in the market where people are just thinking that things would just go straight up? Exuberance doesn't even begin to cover it. The first 13 days of 1987, the Dow did something it had never done before and has never done since. It gained 13 straight days in a row.

At the market's top in August, was up 43% for the year. I think that would have made it the sixth or the eighth best year ever if it could have just held on to that. So exuberance doesn't even begin to describe it. Much of it was a function of corporate raiders who had started to recognize the unrecognized value, previously unrecognized value in a lot of stocks, and they were buying them up. And so we got into a situation where everybody felt like they could buy a stock confident that some raider would come along and bid it even higher. Yeah, really the era of greed is good. To Joe's earlier point, I'm wondering, you know, nowadays

we talk a lot about the potential for quant funds or systematic funds or risk parity funds to spark a broad sell-off in the style of portfolio insurance. In the 1980s, was anyone talking about the risks of portfolio insurance or, you know, the downsides of Black Shoals before it actually happened? Even the inventors of portfolio insurance realized that it had some limitations. When they went into sales meetings, they would say that this will work until something like, in the analogy they used was the Soviets invade Iran. There were some other people who were talking about it, but you really had to be pretty geeky in order to have gotten that message. It was actually precisely a week before the crash that an article appeared in the Wall Street Journal by Beatrice. Garcia, that really introduced people to the fear of portfolio insurance.

All right. I want to skip ahead to actually what I think is, I don't know if it's my favorite crash, but it's the one that I feel like I know the best because I sort of came of age during it, and that is the late 90s bubble. I was a student in high school. I got really obsessed with the market then, and I think it was a good chance that due to that timing is the reason I'm in financial media today because I just found the whole thing fascinating. When did that bubble start in your view? That's a great question. I don't talk

about what happened in 2000, 2001, 2002 in my book. I don't consider that quite a crash. It took place over actually several years. It had several down legs, first of all, starting in March of 2000, and then with 9-11. But when did that? When did that? When the bubble of the 1990s start, I think it would have to, I look at it as something that started with the Apple Super Bowl ad that ran one time, because that really started to put the personal computer and personal technology front and center in people's thinking. And that's, I think, when that market really started taking off. I have a conceptual question, which is, you know, after bubbles burst, we always talk about the pricing as having been irrational.

But the run up to all these bubbles actually often has a rational explanation. There's usually a narrative to accompany it, right? Oh yeah, there's always an explanation, unfortunately. So in terms of those explanations, I mean, what is it about human nature that we always buy into those explanations? and we're never more skeptical of the story that we're hearing. It's a phrase that we've used before. The phrase is, it's different this time. It is so easy to convince ourselves that it is different this time.

In 1929, we had not really seen, we'd seen a single modern stock market crash in 1907. In 1987, it had been so long since we'd had a crash, 50 years. that I think people just forgot that they could happen and they thought we are much more sophisticated, much smarter now than we were then. I think it's just the hubris of humankind where we just think we're smarter and it's different this time. I have another human nature question and it concerns the post-crisis period because since 2009, we've essentially been in this nonstop bull market. There's been a few blips along the way. That being. said throughout this rally, numerous people have been talking about bubbles or the crash is going

to come back anytime soon. And so in a way, rather than this period being characterized as care freedom or buying into a new story, there's been this underlying deep pessimism that's prevented a lot of people from actually participating in this rally and this belief that the next 2008 could happen any minute from now. Well, and a lot of those people have something that they want to sell you. They want to sell you a newsletter. They think that you should be buying gold or whatever. But I think you make a great point. And that is if there's so much skepticism, it's hard to think that we're going to have a crash.

Now, we know the market can pull back substantially. Nobody is saying that it can't. But with interest rates as low as they are, if interest rates were going to go substantially higher over the next couple of years, then the market could very well be in trouble. But I just think that you're absolutely right. There's so much skepticism that it's tough to think we're really going to get, say, bubble issues. There's skepticism, but on the other hand, you know, I really like the way city analysts once phrased or once characterized a bubble, they said it was something that I get fired for not owning. And in that sense, you can complain about valuations as much as you want. But if you have to invest money, well, then you have to put it somewhere other than cash. And so it's either going into stocks or credit. But Scott, to Joe's point, if there was one thing that you could pinpoint, as a suspicious sign when it comes to identifying a true bubble, what would it be?

That's a great question. In my experience in my book, I talk about several similarities that each of the crashes share. There's always some new financial contraption. I think that if we can see something that is starting to capture too much, too many assets, then that would be a problem. Interest rates too low for too long are the reason that 1929 and then 2008 happened. So if you want to look now and say, boy, interest rates have been too low for too long and the Federal Reserve seems just terrified of raising Fed funds rate past 1%,

or of starting to shrink the balance sheet, that might be the thing that would scare people right now. And as Tracy mentioned in the beginning, one of the really, well, let's be honest, one of the cool things about bubbles is that you could get rich in a really short period of time. And the only thing you have to do to get rich during a bubble is to sell before everybody else sells. As long as you could do that, that bubbles are great. So when you look at these crashes, and your book is A History of the United States in five crashes, are there any common themes out there that? that sort of foretell the imminent collapse so that people know to, you know, get out the door before everybody else does? Well, the problem, it's a fascinating question. The problem is that, and I mentioned these catalysts, and there's always a catalyst, the problem is that the time between the catalysts and the crash is collapsing. It was a year between the catalysts for the 1907 panic and the actual panic.

It was a year. In 1929, it was about a month between Hatchery and the crash. In 1987, it seemed the Friday before the crash seemed like we'd finally gone to war with Iran. So that was a weekend. And we haven't talked about 2010, the flash crash, but the catalyst for that happened the day before the crash. So we've gone from waiting a year and then a month and then a weekend and now a day. The problem is as the time between the catalyst and the crash collapses, then there's less opportunity for people to do what you're suggesting. Real quickly, you mentioned the catalyst for the 2010 flash crash. What do you identify that as?

Oh, I think it was clearly the rioting, arson, and murder in the streets of Athens. On May 5, 2010, it seemed just absolutely obvious that all of the Greek society was going to come apart, and that as a result, the Eurozone was going to come apart. It seemed absolutely certain. A million people were in the streets of Athens, A bank had been firebomb, three people had been killed, not just killed, murdered. Three young people who'd come back to Athens to continue their careers when they didn't need to come back to Athens. And that and the fact that on the 7th, we were going to get a non-farm payroll number, the writing in Athens was just obviously the catalyst for what happened. Scott Nations, the author of A History of the United States in Five Crashes,

market meltdowns that defined a nation. Thank you so much for joining us. Fascinating conversation. I'd love to have you back one day to just like talk more about 1929 because we could do like two hours on it. But that was great and a great start to our bubble series. Thanks so much. It's been tremendous fun to be here. Joe, I thought as you said, that was a fantastic start to our series. I love drawing analogies between previous bubbles. And I have to say the idea that the window that you have to get out first from a bubble ahead of an imminent crash. The idea that that is shrinking rapidly, that really resonates, especially when we think about the way markets are more computerized nowadays, but also just the way information gets disseminated so quickly nowadays.

Yeah, I hadn't even thought about that, but that is a great point I thought. And it was one that hadn't clicked to me at all. But it seems easy to say on the way up. It's like, yeah, I know it's kind of irrational. It's a bubble, but I'll just be prudent. But if the, you know, if the crash can happen that fast, probably there are a lot of people who imagine they'll be prudent and not actually be able to act on it. Yeah, exactly. All right, should we tease some of the other bubbles that we're going to be discussing during this series? Wait, I just want to make one more point, too, that I really like from Scott. And that is the sort of, what is he characterized the new financial contraption at any given moment. Because I think it's, you know, and I think we look at,

you could sort of tell that you need, obviously there's the financial conditions puzzle, often characterized by low interest rates. There's the sort of optimism part of the puzzle, the idea that some new technology like the internet or the radio is going to get people excited. But this other thing that there's some new tool for investing, whether it's the CDO or the online broker in the 90s or whatever it is or the mutual funds in the 20s, that there has to, and of course, now, you know, people are very concerned about ETFs and other things like that. We don't know exactly. Seems like a very important point I had never really, like, put together before. Yeah, it's interesting that those new creations often come from, I don't want to say, like,

a good place, but if you think about the investment trust of the 1920s, that was really supposed to democratize finance and make it easier to invest. And the same thing for ETFs now, right? You know, you're supposed to be able to get easy and cheap access to stocks. You could even argue the housing bubble going into 2008. You know, the government was trying to increase home ownership. Anyway, all right, other bubbles. I think there's a quote about the road to good intentions or something like that or the road to hell that I think applies here. So let's real quickly, yeah, as you mentioned, tease ahead to some of our future episodes. What are you excited to talk about? Well, you know, I said 1929 was the quintessential bubble and crash, but there's one that is even more

classic, and that has to be the tulip bubble. I'm very excited to talk about that one. Although I am very much, too. I know there's a lot of debate about that one, about how much of it was real and how much it was a myth. But it is the number one thing that when people think bubble like, ah, it's tulips again. And so I feel like I can't wait to really dive into that. Also, because I'm super into the 20s, I'm excited we're going to talk about the 1920s Florida real estate bubble, which was sort of a precursor to the overall crash. And there are just some fabulous stories that came out of that. So I am very excited about continuing this series. Yeah. All right. So everyone should keep on listening because those episodes and many more will be coming out in the coming weeks.

But that is it for the first edition of our Bubbles series. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Jill Wisenthall. You can follow me on Twitter at The Stallwork. You can follow Scott on Twitter at Scott Nations and our producer Sarah Patterson, Sarah Pat with two teas. This has been another episode of the Odd Lots podcast. Thanks for listening. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories.

Episodes are published throughout the day with the latest information and data to keep you informed. Yes, there are other products like this from a variety of news organizations. But they usually rerun their radio newscasts throughout the news. day. That's not what we do. We create customized episodes that can only be heard on Bloomberg News Now. And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts we're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen.