After reading Charles P Kindleberger's 1970's classic, one begins to wonder if a Financial Mania is not always taking place somewhere in the World. The US crash of 1987 was added to a revised edition of the book. This mania/panic was soon followed by the Japanese peak @ 39000 Nikkei in 1989. The 1997 Asian markets' collapse will probably be added to some future edition, and so it goes on.

The $64000 question is whether a future edition will include a chapter or two on the US mania (and panic) at the turn of the century.

Mr Kindleberger's analysis of manias is helpful in that it outlines the basic ingredients necessary to produce a mania; The role of the Central Bank or some other 'lender of last resort' plays in a financial mania; the stages of a mania and how to tell when a mania is about to transform itself into a Panic!

 

1. A first preparatory stage of a mania is 'economic displacement' or an outside event that is a shock to the financial system , such as the beginning or ending of war, a huge bumper harvest or a revolutionary invention. Whatever the source of displacement, it is large and pervasive and will alter the economic outlook by changing profit opportunities in at least one important sector of the economy.

It's what makes the economic cycle appear "Different this time" to investors and is the catalyst to an elongated economic expansion. PERHAPS THE END OF THE COLD WAR AND THE BIRTH OF THE INTERNET BOTH QUALIFY AS SUFFICIENTLY LARGE AND OUTSIDE EVENTS AND ARE THE ECONOMIC DISPLACEMENTS OF THE 1990's.

2. 'Mismanagement of Credit' is also required to drive prices to unreasonable levels.

Mr Kindleberger often refers to Hyman Minsky, a monetary theorist from Columbia University who also had a model for financial crisis. In Minsky's model, the boom is fed by an expansion of bank credit that enlarges the total money supply. MISMANAGEMENT OF CREDIT IN ANY SITUATION, REGIONALLY OR GLOBALLY, IN WHICH EITHER INTEREST RATES (OR REAL INTEREST RATES) ARE EXTREMELY LOW OR THE AVAILABILITY OF CREDIT (LOANS) IS EXCESSIVELY HIGH.

This reminds one of recent record breaking low interest rates of Japan (to avoid deflation) and Europe (EMU policy). In the United States, mismanagement of credit took the form of industries built upon subprime lending, ubiquitous credit cards and mortgagtes available for 125% of the value of a home.

This 'MISMANAGEMENT OF CREDIT', a foundation of manias, is clearly apparent in the 1990's world situation.

3. 'Attracting the Crowd' is an obvious requirement of any boom , whether financial market related or not. Prices will continue to rise until price exceeds value and is truly only in the eye of the beholder.

"Positive feedbacks develop, as new investment leads to increases in income that stimulate further investment and further income increases ....." the result of which is often called 'overtrading' or 'overestimation of profits comes from euphoria'.

When a large number of firms and households indulging in these practices grows large, including segments of the population who would normally avoid such ventures (retirees and blue collar workers come to mind), speculation for profit divert from the normal rational behaviors to what has been described as 'manias' or 'bubbles' !

As a speculative boom continues, interest rates, velocity of circulation and prices all continue to mount. There are signs today of higher interest rates in Japan, which could push US rates higher.

4. Stages of the Boom/Bust

   Mr Kindleberger's book identifies the progression of Manias, Panics and Crashes as DISPLACEMENT, MONETARY EXPANSION, OVERTRADING, REVULSION/DISCREDIT/DISTRESS, PANICS AND CRASH. Today's analogy could be:-

   DISPLACEMENT End of Cold War, the Technology/Information age and creation of the Internet.

   MONETARY EXPANSION Global money supply has been extremely loose.

   OVERTRADING Let's trade all day. Every dip is a buying opportunity. Nothing can stop these prices from going up.

   DISTRESS Why aren't my stocks going up?

   Fire my Broker!

   Higher oil prices are not inflationary!

   PANIC Oh my God, why did I re-mortgage my house to buy stocks.

   CRASH Sell everything.

5. Distress

   Whilst he who cares to look can see ample evidence of the recent boom in US Equities, identifying the distress stage is of utmost importance. There is no standard interval between the beginning of financial distress and eventual panic, it may be a matter of weeks or years. However, modern technology and telecommunications suggest that the warning phase, or distress could be a much shorter period than before.

   Investors should be alert to the point at which core beliefs regarding the mania begin to be challenged, as this marks an important turning point for the market. Today's core beliefs are that of low inflation and predictable equity performance.

   A less obvious sign of a top is of fraud and bankruptcies, albeit that many times these symptoms will not appear until after the crash. The Japanese bubble was a perfect example in which fraud within the brokerage industries and ties to the Mafia were identified after the Nikkei fell from 39000 to 14300!

   Distress may arise from external drains. Bad harvests, requiring imports, tight money abroad that attracts domestic funds, a return of foreign capital to its usual habitat. (Look at reversal of foreign ownership of US Treasuries).

   Other recent concerns must include the cumulative advance/decline line of US stocks. The divergence is one of the greatest on record. Since April 1998 a greater number of stocks have been declining than advancing; market leadership has narrowed and the broad market has NOT been producing profits for investors and finally interest rates are on the rise.

   A study of Margin Debt by Warburg Dillon Read (6/99) gives further concern in respect of signs of distress. They identify that not only is Margin Debt at an all time high ($173 Bn approx) but that this measurement can assist in identifying market peaks.

   Margin debt is up sharply in recent months, quality is deteriorating, and the level relative to both NYSE market capitalisation and GDP is relatively high. None of this suggests that the public investor is in a good position to sustain a substantial market correction.

6. Lender of Last Resort

   Central Banks are the Lenders of Last Resort. Mr Kindleberger stresses that investors should always have doubts about the Lender of Last Resort - in other words, the rescuer in the case when financial markets fall apart. Investors should question whether a safety net exists in the event of a financial emergency and whether it would be rescued.

   If there IS A PERCEIVED SAFETY net, the financial mania is likely to go on much longer and much further since there would be little perception of risk by investors. The role of the Federal Reserve in the second half of 1998 (lowering rates, re-organising long term Capital Management) clearly worked in favour of furthering the financial mania by lowering the perception of risk for most investors.

   Financial mania is particularly difficult for the central bank if accompanied by falling commodity prices, since this lessens the ability of the central bank to curb the mania by raising rates (The current cycle was further handicapped by the Asia debacle, which was deflationary). Mr Kindlegerger further questions whether mania can be halted by official warnings. The evidence suggests that they cannot. A familiar ring would be Fed Chairman Alan Greenspan's 'irrational exuberance' speech of December 1996.

   Mania has a clear bandwagon effect of attracting advocates as they go along. Those who speak out against the mania will often be ridiculed, derided and perhaps become at risk of losing their job.

   In reality, the Lender of Last Resort only plans an active role AFTER prices have fallen. If there is no Lender of Last Resort, as in 1873, 1890 and 1931, the depression following a financial crisis will be long and drawn out. Best we watch the re-appointment (or otherwise) of Mr Greenspan in June 2000.

7. Parallels and Conclusions

   We are struck by the repetitiveness and diversity of the financial 'boom, distress, panic' , cycle throughout history. It is easy to see the similarities between Mania, Panic and Crashes and today's financial marketplace.

   The signs - mismanagement of credit; extreme equity valuations; Mr Greenspan's warnings;  hot real estate markets in New York, Boston, San Francisco and London; the Internet bubble; individuals giving up their day jobs to trade stocks full time; recent SEC investigations into Broker fraud and accounting "irregularities"; the financial distress in Asia; and even the recent rise in crude oil prices - all fit a pattern found in this book written several decades ago.

   Kindleberger's bubble phase typically lasts a year or two. Greenspan warned of excesses in December 1996. If correct, the overvaluation is more than two years old (perhaps extended by the deflation of commodity prices and Asia). The Fed's rate cuts of 1998 also supported higher prices.

   It may not be popular but we warn - IT IS NEVER DIFFERENT THIS TIME - FOR A GRAPHIC ILLUSTRATION CLICK HERE !!!

    

   Charlie Aitken                                 August 1999

   The author expresses thanks to Manias, Panics and Crashes by Charles P Kindlegerger (John Wiley & Sons Inc 1978)

   The views expressed are those of Summit Money Management Ltd  Under no circumstances is it to be used or considered as an offer or recommendation to acquire any securities. While all reasonable care has been taken to ensure that the information is not untrue or misleading, it should not be relied upon to make investment decisions. You are reminded that prices fall as well as rise