There is a joke in financial history that every generation thinks it has just discovered something new. A new asset class. A new analytical technique. A new reason the normal rules don't apply. The joke is that this belief is itself the oldest recurring pattern in the history of markets, and that the belief's arrival is, statistically, one of the most reliable signals that a disaster is about to occur.
What follows is a short tour of six stock market disasters from the last four hundred years. I am not going to try to cover every bubble. I am going to describe six that illustrate six distinct failure modes, and I am going to argue, at the end, that these six modes recur in different combinations and will recur again, because the things that make them recur are not problems of finance but problems of human cognition under conditions of social pressure.
I. Tulipmania · Holland, 1636–37
The canonical early bubble. Dutch investors spent much of 1636 bidding up the prices of rare tulip bulbs to astonishing levels. At the peak, in February 1637, a single bulb of the Semper Augustus variety sold for roughly ten times the annual income of a skilled craftsman. The bubble popped, violently, over the course of a few days in February 1637. Prices collapsed by 90% or more. Many fortunes were lost; a handful were made by those who had sold early.
The tulipmania is interesting because it is often cited and mostly misunderstood. The actual economic damage was probably modest by the standards of later bubbles. The Dutch economy did not collapse. What tulipmania gives us is the shape of the pattern: an asset becomes fashionable, prices detach from any fundamental value, new investors arrive who are buying purely because prices have risen, and then, at some fairly arbitrary moment, confidence breaks and everyone tries to sell at once. The shape is the lesson. The tulip itself is almost beside the point.
II. The Mississippi Bubble · France, 1719–20
Far more consequential than tulipmania, and far less well-known. John Law, a Scottish economist, persuaded the French regent to let him establish a central bank issuing paper money, backed by a monopoly trading company that claimed to have rights to the vast wealth of the Louisiana Territory. The company's stock rose by a factor of forty in 1719. Then it fell by 95% over the course of 1720. The French currency was catastrophically devalued. The French state's finances were damaged in ways that historians have argued contributed, seventy years later, to the conditions of the Revolution.
The instructive thing about the Mississippi Bubble is its respectability. John Law was, genuinely, one of the most sophisticated economic thinkers of his generation. His theoretical work on money and credit is still studied. The bubble was not perpetrated by a con artist. It was designed and executed by the leading economic mind of the age, endorsed by the French state, and consumed by educated investors who had every reason to think they were participating in a reasonable venture. Smart people, good intentions, sophisticated theory. Total disaster. This combination recurs.
III. The 1929 Crash · United States
The one everyone knows. Stock prices in the United States rose dramatically through the 1920s, fueled by margin buying, industrial optimism, and the widespread conviction that a "new era" of permanent prosperity had arrived. The Dow Jones peaked on September 3, 1929 at 381. It bottomed out on July 8, 1932 at 41. A decline of 89% over nearly three years. The subsequent Depression was the worst economic catastrophe in modern Western history.
The 1929 crash taught regulators a great deal. Most of the architecture of modern American financial regulation, the SEC, the separation of commercial and investment banking under Glass-Steagall, deposit insurance, was built directly in response to what had gone wrong in 1929. Most of that architecture has since been weakened or dismantled, for reasons that always sound persuasive at the time and that would have sounded persuasive to the people building the original regulations if they had not just lived through 1929.
For a longer list of great minds making a financial mess of themselves, a small blog called Mortal Legends has a running catalog of it. Their Newton piece is the gateway drug. But there is a whole back-alley of Victorian scientists and Edwardian novelists who lost small fortunes in similarly dignified ways. If this article amused you, the archive probably will too.
IV. Black Monday · October 19, 1987
The Dow Jones fell 22.6% in a single day. It remains, in percentage terms, the worst single-day stock market decline in U.S. history. What makes Black Monday interesting is that, economically, nothing much happened. There was no triggering news. No geopolitical event. No corporate collapse. No macroeconomic report. Markets simply fell, and kept falling, driven by an interaction between portfolio insurance (a new computerized trading strategy) and market makers who withdrew liquidity as losses mounted.
The instructive thing about 1987 is that it shows what happens when the plumbing of a market, the systems that match buyers to sellers, breaks down under stress. The "fundamentals" were fine. The market was not. This is a failure mode that is, if anything, more dangerous now than in 1987, because the plumbing is more complex and the automated systems are deeper. Nobody I have read on this subject thinks we have fully solved the problems that 1987 exposed.
The "fundamentals" were fine. The market was not. This is a failure mode that is more dangerous now than in 1987, because the plumbing is deeper.
V. The Dot-Com Bubble · 1995–2002
NASDAQ rose from roughly 1,000 in 1995 to 5,048 in March 2000. It fell to 1,114 in October 2002. The internet companies that led the rise were, in many cases, not yet profitable. Some had no plausible path to profitability. The market bid them up anyway, on the theory that the old rules of valuation did not apply to a fundamentally new kind of business.
The dot-com bubble is instructive because the underlying insight was substantially correct. The internet did transform the economy. Many of the companies that failed in 2000–02 would, in retrospect, have been plausible businesses if they had had ten more years of runway. The failure was not that the thesis was wrong. The failure was that the thesis got ahead of the execution. Prices assumed immediate fulfillment of an outcome that would, in fact, take another fifteen to twenty years to arrive. Even true theses can produce bubbles if the market prices the outcome before the timeline supports it.
VI. The 2008 Financial Crisis · United States and Globally
The most recent of the truly major disasters. A combination of subprime mortgage lending, securitization that obscured the underlying credit quality, insurance products (credit default swaps) that concentrated rather than diversified risk, and regulatory arbitrage that moved activity to less-supervised parts of the financial system. When the housing market began to decline in 2006–07, the chain of dependencies produced a cascade of failures that nearly brought down the global financial system.
What 2008 illustrates is the central flaw in modern financial risk management, the assumption that risks are independent. They are not. When housing prices started falling nationally, the entire structure of mortgage-backed securities, which had assumed that regional housing markets would not correlate, failed simultaneously across the economy. The models that had priced the risk did not model this correlation. The same error, in slightly different form, was what destroyed Long-Term Capital Management ten years earlier. It will, I suspect, destroy something else in the next decade.
The pattern
Six disasters. Three hundred and seventy-odd years. The specific mechanisms vary, tulip bulbs, trading companies, new technologies, automated trading systems, complex derivatives, but the pattern, at a high level, is almost identical each time:
A new asset, technology, or product emerges. It is, in fact, genuinely valuable in some respect. Prices begin to rise. New participants, attracted by the rising prices, enter the market. Prices rise faster. Sophisticated participants develop theories that explain why the normal rules of valuation do not apply to this new thing. Prices rise faster still. Unsophisticated participants, seeing that their friends have made money, enter at or near the top. Something small happens, a loss of confidence, a regulatory shift, a single failure in the underlying assumption, and the asset's price begins to fall. The fall feeds on itself, because many participants were holding the asset on credit and have to sell to meet margin calls. The price drops below its starting level. Fortunes are destroyed. A regulatory response is developed. The response is, twenty years later, weakened in the name of flexibility or efficiency. The cycle repeats.
I do not think this pattern can be broken, because the pattern is not about finance. The pattern is about how humans behave in crowds, under conditions where other humans appear to be making money and they are not. This is a feature of human cognition, not of markets. You can build regulatory systems to dampen the cycle. You cannot eliminate it. The next bubble is, almost certainly, already under way somewhere. The person who recognizes it may not be the person who can stop it.
The best we can do, most of us, is to recognize when we ourselves are being caught up in the pattern, and to remember, from the history, what the ending usually looks like.