In 1867, while standing in front of the Manchester Statistical Society, John Stuart Mill delivered the future template for market bubbles.
…that during each of those decades commercial Credit runs through the mutations of a life, having its infancy, growth to maturity, diseased over-growth, and death by collapse; and that each cycle is composed of well-marked normal stages, corresponding to these ideas in nature and succession. And as Credit is a thing of moral essence, the external character of each stage of its development is traced to a parallel change of mental mood…the malady of commercial crisis is not, in essence, a matter of the purse but of the mind.
Mill looked at previous panics thinking that some general pattern would emerge. He was right. He saw a dramatic shift in mindset throughout the cycle: from panic came revulsion, to caution, moderation, then euphoria, and back to panic. Mill hoped that being able to recognize the mood swings could help avoid future disaster.
Mill broke the cycle down into three stages, attaching a mindset to each.
- The Post Panic Period
- The Middle or Revival Period
- The Speculative Period
The Post Panic Period is the recovery after a crisis. It’s defined by the shift from preservation and revulsion to distrust and caution.
As a secondary consequence of the new mental mood of the lending classes, the owners of loanable Capital. The first consequence of that mood was, as we have seen, excessive scarcity; because, in the supreme moment of the crisis, the grasp of each capitalist closed tight upon his own means… But when that moment has passed, and its first terror has subsided, the private capitalist no longer feels the instinct of self-preservation, demanding absolute personal possession of his means… The Capital thus released from durance, does not at once flow back into the channels of loan and discount, from which it had so suddenly been withdrawn. Like the uneasy swell of the sea after the turbulence of recent tempest, there is a remainder of distrust, quieter but more enduring, and this dictates a much more rigid selection of securities, and concentrates the deposit of loanable Capital upon a few important centres…
Gradually, the mood lifts and Mill describes it as an eventual turn to “normal”.
No doubt a new confidence begins to germinate early in this period, but its growth is slow. The old race of traders have still a vivid remembrance of a “black Friday” or some other day of equally sombre hue. Time alone can steady the shattered nerves, and form a healthy cicatrice over wounds so deep. And that process suffers rude interruptions. Houses which — surviving the first shock — were rendered too weak to endure through a long period of dormancy and doubt, occasionally succumb, and so renew unpleasant sensations… In the main, however, there is progress. Speculation having long ceased to forestall the markets, the actual wants of the world begin to emphasise demand, and so to tell upon prices. New and young firms begin to be formed, with no drag of deterrent experience upon their movements, and anxious to be “doing business.” Even old firms, though less eager and more wary, are wishful to utilise the costly apparatus they are compelled to keep up, and to fill the gaps in their Capital by new gains.
The arrival of “normal” leads to a prosperous Revival Period. There’s innovation, new business startups, and a healthy level of confidence.
In fact, and notwithstanding all drawbacks, this may be considered the healthiest period of our commercial life, and that in which accumulations from real — as distinguished from merely nominal profits — attain their highest developement… It is in these periods that new commercial and manufacturing concerns mostly spring into existence, tempted by the high ratio of current profits.
But a new generation of “traders” is needed to get to the step in the cycle.
…there must be a large percentage of new men, to whom the grim story of past panics, and of the nemesis of over-speculation, is a mere myth, or at most a matter of hear-say tradition. We know the tendency of the human mind to take from present conditions the hues of a forecasted future; and not less certain is the unfortunate fact that the existing system of culture amongst our commercial classes is but little adapted to correct the want of personal experience. It is the student who watches for movements and changes; the great majority of men habitually assume that what is is what will be, and it is under the influence of this idea that a healthy growth gradually merges into dangerous inflation. Concurrently with this state of matters, the actual increment of Capital from profits begins to overflow the usual channels of investment; and in seeking for new channels, the habit of contemplating a high scale of profits makes men look over old-fashioned modes of investment to others which promise better things.
The last stage of the cycle isn’t possible without some youthful ignorance. Excessive speculation is needed and the most direct way to get it is via people who have no sense of history. It’s easier to believe prices only go one way when you don’t know the long history of excess and euphoria that deliver dangerous bubbles.
Unfortunately, however, in the absence of adequate foresight and self-control, the tendency is for speculation to attain its most rapid growth exactly when its growth is most dangerous…
And what is it, then, that really underlies this new condition of things? It is a further change in the mental mood of traders… There is a morbid excess of belief, an hypertrophy of belief, induced by an excess of nourishment to that faculty of the mind. In the speculative period under review, the healthy confidence which marked the middle period has degenerated into the disease of a too facile faith. The one fact of an apparent profit is for the moment held as full warrant for ever new commitments. And this is not confined to the commercial classes. The investing class of non-traders easily takes the infection. And, as demand always stimulates supply, there is at such times no lack of channels for the inflow of this confidence; every one of them, of course, a Pactolus. The admirable modern invention of Joint Stock Companies has an almost infinite absorbent capacity; and the crowd of morbid-minded investors in financial and industrial enterprises, of various degrees of merit, do not, in their excited mood, think of the pertinent questions, whether their capital will become quickly productive, and whether their commitment is out of proportion to their means. The commercial and investing classes thus come under an enormous amount of obligation, dependent for its success upon the one precarious condition of a continuance of the existing scale of prices…
Speculation, growing more and more reckless, has thrown goods upon the markets faster than they can be absorbed, producing an oppressive glut, beneath which prices must inevitably give way. With the first symptoms of such a result…and sales of goods more imperative. Prices consequently recede further, and then further; and the downward impulse being once given, it does not cease until the fall is out of all proportion to the previous gradual rise.
Simply, the presence of euphoria sows the seeds of impending doom. Mill even cautioned using margin to invest when speculation is high, to avoid forced selling when prices collapse.
It turns out, Mill’s prescription — education — has prevented few bubbles since. Still, education is the go-to for avoiding the next disaster. The more you know and understand market cycles and the history of past bubbles the more likely you might recognize the mood swings and not get caught up in it yourself.
On Credit Cycles, and the Origin of Commercial Panic by John Stuart Mill
Ben Graham on Market Cycles and Second-Level Thinking
Philip Carret on Forecasting Market Swings
Howard Marks: Lessons from a Crisis