The idea of "rational bubbles" is an oxymoron, says Robert Prechter, and he explains why in the talk he gave at the recent 2011 Socionomics Summit: New Horizons in the Study of Social Mood. To find out more about what really causes financial bubbles and how the Wave Principle helps forecast them, dive into this edited excerpt from Prechter's talk, which he published in the April Elliott Wave Theorist.
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Rationality All the Way
Much academic literature embraces the idea of “rational bubbles,” which in my view is an oxymoron. No matter how many times I read explanations of why chasing stock prices after an extended uptrend constitutes a rational assumption of risk, I cannot resolve the idea with either observed behavior or the typical outcome for investors, which is massive losses. I never seem to read a paper arguing that buying after an extended downtrend is a rational assumption of risk, although it certainly beats bubble buying. As we will see below, running with the herd is not an occasional event but constant; and it is not rational but self-destructive.
The case for rational bubbles rests on the idea that investors are consciously making risk assessments and deciding that the gamble of buying high -- to sell even higher -- is worth it. But a bubble is fueled by more buying, which is propelled by new buyers and by increased conviction among those already invested, so few bubble investors actually do sell higher. Instead of buying high and selling higher, most of them do only the first half.
Socionomics argues that bubbles and crashes are inconsistent with rational risk assumption but entirely consistent with non-rational risk aversion. Whether buying or selling, investors are unconsciously perceiving less risk. When buying, they are acting like a gazelle loping along after the herd in hopes that others know where the water hole is. When selling, they are acting like the gazelle that runs in panic because others are running. In neither case is there any thought of taking on risk, rationally or otherwise.
Investors often pay lip service to the idea of taking on risk. But they don’t mean it. All such thinking is merely rationalization. The neocortex has to do something at times when impulses are directing its host’s behavior, and in such contexts it resorts to rationalizing mood-induced imperatives. In financial markets, rationalization is constant. It is the basis for the vast bulk of commentary justifying buying or selling financial assets. Reason doesn’t figure much into the picture at all.
Temporary Irrationality
Most books and professional literature relating to financial bubbles take a middle ground. They assert that markets are usually rational but every so often people become susceptible to a financial mania and subsequent crash. Then everything returns to normal. Thus, bubbles are special circumstances akin to temporary insanity. For some still unknown reason, a financial market becomes the focus of speculation, and people abandon reason to chase impossible dreams of riches. Irrationality spreads by contagion until it reaches fever pitch. Then reality imposes itself on the proceedings, causing a reversal. Extreme values collapse, causing financial ruin. Eventually, investors sober up and return to their natural state of rationality. From Mackay to Kindleberger and beyond, this is the accepted version of bubbles. …
The first problem with this position is that there is no demonstrable norm of objective pricing…. [Read full explanation in the April 2011 Elliott Wave Theorist.]
The second problem with popular bubble theory is that there is no evidence that investors’ behavior ever fundamentally changes. Descriptions of bubble conditions assert qualitative differences in behavior, but socionomics and the Elliott wave model suggest that they display nothing but quantitative differences. During a bubble, more people engage in investing more intensely, but the same type of change occurs on a fractal basis all the time, as illustrated in Figure 7.
.GIF)
Under the Elliott wave model, extreme pricing occurs during fifth waves of large degree. And since fifth waves are followed by the largest bear markets since the five-wave sequence began, the “mania” or “bubble” is naturally followed by a severe retrenchment. That’s all there is to it. When it happens at Minor, Intermediate or Primary degree, people hardly notice. But when it happens at Cycle and especially Supercycle degree, they think it’s a new animal, bubble literature describes only the historic extremes.
According to socionomics, investors are herding all the time, not just in bubbles and crashes. The agents involved are a homogeneous group. Under the socionomic model, there are no investors vs. traders, technicians vs. fundamentalists, or smart money vs. dumb money. Differences among participants are
quantitative, not qualitative, as some people herd sooner or more intensely than others. Although some investors may be smarter than others, in the end everyone herds to some degree.
We can demonstrate the value of the socionomic version of bubbles, because in 1983 the Elliott wave model served to
forecast a bubble. The text of this forecast is in the appendix to
Elliott Wave Principle and the Foreword to
Conquer the Crash, but it is reprinted again here for convenience:
Given the technical situation, what might we conclude about the psychological aspects of wave V? The 1920s’ bull market was a fifth wave of a third Supercycle wave, while Cycle wave V is the fifth wave of a fifth Supercycle wave. Thus, as the last hurrah, it should be characterized at its end by an almost unbelievable institutional mania for stocks and a public mania for stock index futures, stock options, and options on futures. In my opinion, the long term sentiment gauges will give off major trend sell signals two or three years before the final top, and the market will just keep on going. In order to set up the U.S. stock market to experience the greatest crash in its history, which, according to the Wave Principle, is due to follow wave V, investor mass psychology should reach manic proportions, with elements of 1929, 1968 and 1973 all operating together and, at the end, to an even greater extreme.
-- The Elliott Wave Theorist, August 1983
Future Nobel-Prize-winning economist Robert Shiller recently wrote in The Wall Street Journal that bubbles can’t be forecast. They can’t be, under conventional theories. But they can be, under the Elliott wave model. If one can forecast a bubble using a model based on uniform investor behavior, then it is likely that investors’ behavior is uniform.
Socionomic theory does not rely on either tautological rationality or inexplicable departures from a psychological norm. According to socionomics, non-rational pricing is the norm.