Panics emerge as markets crash down to earth after they have risen beyond levels that are sustainable. A useful model for tracing the stages which lead to a panic is supplied by Charles Kindleberger in his book “Manias, Panics and Crashes”. He built on the model that was established by monetary theorist Hyman Minsky.
Outlined below are the stages.
Cycle starts with some kind of shock to the system that creates important opportunities for at least one sector of the economy. It could be an extraneous event such as a war or some even more closely connect to the economy eg. rise of the Internet.
This event starts a boom, which is then fuelled by the expansion of bank credit and enlarging money supply.
With more cash in hand, euphoria takes hold, leading to what is termed ‘overtrading’. This term can mean a number of things, such as heavy speculation in anticipation of price rises or it could mean excessive gearing, caused by buying speculative assets on margin.
News spreads of the spectacular profits being made by those involved in this trading. Kindleburger once said, “There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”. So everyone else wants to get rich and a bubble forms. People who previously had never even thought about buying stocks suddenly start entering the market.
The real danger signals appear when stock market news moves from the back to the front pages of non-financial newspapers. Illustrating this point was the alarming appearance of mutual funds as a Playboy magazine cover story at the height of the 1990s stock market boom. When stocks replace scantily clad young ladies with large mammaries in the most honoured position of a magazine such as this, logic has clearly taken a back-seat.
Not only does the stock market suddenly become inundated with inexperienced players but their very presence increases demand to sell all kinds of new equity issues that doesn’t make sense.
As the bubble grows, the markets become increasingly detached from the underlying assets they are supposed to represent.
A number of scams and dubious investments come to the market.
By now, the more savvy investors sense the time has come to head for the exit. Newer players are unsure what to do so they tend to stay put, but the fact that some players are getting out tends to put a brake on the rapid upward movement of prices. Once this happens, there is an increasing movement away from assets into cash, further depressing prices.
By now, the market is in full retreat with even hardened speculators realising that the peak has passed and there is competition to get out before everyone has abandoned the field. This may be followed by a specific event, such as a dramatic bank failure or the revelation of a particular scam.
This accelerates the rush to the exit and leads to revulsion against the very assets which were once regarded so highly.
Source: “Market Panic: Wild Gyrations, Risks and Opportunities in Stock Markets” book by Stephen Vines