Guest Post: Primer #3: The Dangers Of Mass Psychology (Or Why Overwhelming Majorities Are Always Wrong)
Submitted by Ben Rabidoux of Financial Insights
Primer #3: The dangers of mass psychology (or why overwhelming majorities are always wrong)
In our first primer we discussed the notion of deflation and
why a period of deflationary pressure is inevitable. We explained how
inflation is created in our fractional reserve banking system via
credit-based money creation by our banks. We also saw that when people
stop taking out mortgages or home equity lines of credit and instead
begin saving and paying off those debts, it shrinks the money supply and
slows the velocity of money. This is what awaits us and this will
exert tremendous pressures on asset prices, particularly leveraged
assets like real estate and some stocks.
We then looked at whether or not there is a Canadian housing bubble
in our second primer. I hope you now see that when you remove the
anecdotes and clichés from the discussion and instead look at
fundamentals, it is awfully hard NOT to see that house prices are
So today we turn our attention to a subject that is very dear to my
heart: mass psychology. I want you to notice that in a normal,
functioning economy, debt-based money should be created and destroyed
at close to the same rate. Provided the population grows and GDP grows,
there should be a slight upwards bias in money creation. So why have
things gone so crazy in the past 10 years?
Let’s look at some interesting data points. Many thanks to Jonathan Tongue for compiling these graphs.
Graph 1: Mortgage outstanding
Note the parabolic increase in mortgage debt outstanding since 1999.
Graph 2: Growth in personal lines of credit
Note that this is massively parabolic, approaching a near vertical
move. This right here is the ‘wealth effect’ visualized. People have
been more than happy to borrow against their home equity for many years
now, as perpetually rising home prices have made them feel wealthier.
Think about the implications for the broader economy. This consumer
spending has fueled much of the growth we have experienced over the past
10 years. David Rosenberg recently calculated that every dollar of
home price appreciation creates 9 cents in spin-off spending. It’s not
too hard to see that phenomenon in this graph. My position is that as
house prices normalize, there will be a slowing and then a reversal in
personal line of credit growth. This will choke off consumer spending.
Hence, I see a recession in Canada by Q3 2011.
Graph 3: Credit card balance growth
Remember that debt constitutes a claim on future earnings, and
therefore future consumption as it eventually must be repaid. This is
why debt is inflationary in the short-term, but deflationary in the
longer term, paradoxically. So back to the initial question. If
debt-based money creation should roughly equally money destruction, why
the massive boom in debt-based money creation over the past 10 years?
This is the result of group-think. When everyone decides on mass that
it makes sense to take on huge amounts of debt, while very few people
save, a credit bubble is born.
To understand how this happened, let’s rewind the clock back to
the turn of the millennium where two significant events occurred. First
was the crash of the dot-com bubble. Technology stocks reached
massive overvaluation levels in late 1999. The tech-heavy NASDAQ index
in the US was crushed in the following couple years, losing well over 80% of its value in one of the great bubbles of the past couple centuries.
People were burned by this massive bubble bursting. Consumer, who
now felt poorer, began to retrench and the US was back in recession.
Then came 9/11. This further damaged consumer psyche. In response to
all this, the Federal Reserve in the US and the Bank of Canada both
crashed interest rates to encourage consumer spending.
In response, consumers realized that their savings were earning them a
pittance in their GICs and savings accounts. So the savings rate
crumbled in both countries crumbled, with the US actually seeing
negative savings rates for a short period of time.
Remember that as people save, the velocity of money decreases.
Likewise, as they stop saving, leaving more money in the system to
change hands, the velocity increases.
Now central banks can encourage spending, but they can’t channel that
spending. So, consumers who had been scarred by the stock market
decided that real estate was the new safe bet, and the real estate boom
began. It was the events of the early millennium set the stage for this
new prevailing view of real estate to be born. As home prices began
their ascent, more and more people piled in. Home ownership rates
soared. Lax lending standards in both Canada and the US (the ‘prudent
Canadian banking system’ fallacy will be addressed in a later post) led
to a deluge of new buyers. Rising home prices then became the
justification for rising home prices. Eventually everyone became
convinced that real estate rises forever, it is a great investment
(which it can be when the fundamentals are normalized), and everyone
should own. That’s where we find ourselves today.
Here is the connection to mass psychology: Any time people
overwhelmingly believe that an asset is a ‘sure thing’ it inevitably has
to be otherwise. It was John Kenneth Galbraith who astutely noted
that, “In economics, the majority is always wrong”. This is the great
paradox in the world of finance and it is exactly why the contrarians
To wit, consider the following article.
The title is “Majority of Ontarians believe that real estate is a good
investment”. It goes on to indicate that 90% of Ontarians believe that
real estate is a great buy and a solid investment. From other sources I
have seen, this number is fairly consistent across all of Canada.
Faced with such an overwhelming majority who would disagree with me, I
suppose I should probably recant the predictions made in my last
primer and join the party. Well, I’m not quite there yet. In fact,
this only strengthens my convictions that we are at the tail end of a
bull market in real estate. Allow me to explain using a couple of
wonderful graphs and a brief lesson in market psychology. One of the
most amazing things about markets is that when a large majority of
people believe that an investment is a sure thing, it invariably turns
out to be otherwise. Cue the first graph. This one shows mutual fund
manager cash positions in equity (stock market) mutual funds over time.
It sounds intimidating, but it isn’t. The bottom squiggly line
indicates the portion of the fund that is in cash at a given time. The
top line shows the stock market, in this case, the SP500 out of the US.
Why is this significant?
Well, a mutual fund manager will strategically move into cash (sell
stocks) when they believe that the market will go down and there will be
better buying opportunities in the future. Obviously. And when they
believe that stocks will go higher, they reduce their cash position (buy
stocks). What is absolutely astounding is that when taken on
aggregate, mutual fund managers (who are supposed to be the smartest at
picking stocks) are always holding their highest cash positions at times
when the markets are about to take off, and always have the lowest cash
positions at times when the market is about to tank. In other words,
they have it dead wrong virtually 100% of the time. Seriously! The
vertical dashed lines make the connections for you. You see that the
bottom line (cash position) is always spiked higher at times that
correspond with an uptick in the top line (stock market) and vice versa.
This is a very well-studied phenomenon. For a great perspective on
this as it relates to stock markets, I would suggest you read the
following two books: A Random Walk Down Wall Street by Burton Malkiel,
and The Little Book of Common Sense Investing by John Bogle. Both are
fantastic. The two points that must be gleaned from this are as
1) Mutual fund managers aren’t worth the money you pay them. You get
much better value and much better long-term performance by buying an
2) As it relates to all markets, including real estate, anytime that
the majority is convinced that the market is a sure thing, it will
invariably do the opposite, as the majority of the money has already
positioned itself accordingly. In this case, if everyone has sold to
build up their cash position, no one is left to sell. That means that
buying will dominate, and prices will move higher by necessity. The
opposite is also true, and now is the time to make the connection with
real estate. If everyone has bought expecting a higher price, then the
majority of the money is already in play on the buy side, leaving the
sell side to dominate the foreseeable future, with lower prices being
the result of the immutable law of supply and demand.
One more graph will further illustrate the amazing effect of market
psychology. This one is kind of like the inverse of the last graph.
Essentially what it shows is the stock market on the bottom (SP500 out
of the US) and at the top is the percentage of the population who are
‘bullish’ on stocks. Bullish is just a term that means that you believe
stocks will go up. The opposite is called being bearish.
Once again, the blue line at the top indicates what percentage of the
population believes that the stock market will go up. What you will
notice is that, as with the last graph, points of maximum pessimism are
inevitably linked to points at which the stock market is about to break
out to the upside, while points of maximum optimism are always
associated with periods of heightened volatility and times of downward
pressure on stock prices. Amazing isn’t it?
In any market, overwhelming majorities always indicate that the
opposite is about to happen, as the overwhelming majority has positioned
itself (themselves?) to prosper from the ‘obvious’ coming increase in
asset prices. With real estate, 90% of the population currently
believes that it is a good investment (the highest in 12 years). This
has translated into higher ownership rates (the highest in several
generations). So the question must be asked, ‘if so many people have
positioned themselves to prosper, to whom will they sell to to realize
their gains’? And that, my friends is why I am soooooooo unimpressed
when I hear the talk about the massive abundance of real estate bulls
You should not be swayed either. The contrarians always prosper, as
evidenced by the above two graphs, as well as countless academic studies
on market psychology. Public opinion will inevitably shift back to a
dislike of real estate as an asset class. It will be then that I, and
the other smart money, will make a move. I would advise you who may be
considering a purchase to do likewise.
I have long believed that the government interventions back in the
Fall of 2008 did nothing to alter fundamentals. Rather, they dragged
demand forward and exhausted the pool of potential buyers. There is now
a void in potential buyers at the same time that people try to cash in
on their real estate equity en mass. Hopefully you heeded the
advice not to follow the herd!
As a final thought, consider that bubbles tend to follow a particular progression.
I’ll leave it for you to decide where we are on the bubble progression.
Cheers and blessings,