The Madness of Crowds

“I can calculate the movement of heavenly bodies but not the madness of people.” — Sir Isaac Newton (written in 1721 shortly after he lost 20,000 pounds, his life savings worth more than $3 million USD today, in his investment in the South Sea Bubble).

About 120 years after the crash of the South Sea Bubble, another Englishman named Charles Mackay wrote a book about the Bubble and two other events that caused investors to behave irrationally in the extreme. It was called Extraordinary Popular Delusions and the Madness of Crowds. The other events were the Tulip Bulb Mania that peaked in Holland in 1637 and the Mississippi Scheme from 1718-1720, which was a plan to shore up the finances of Louis XIV of France. This house of cards was created and managed by John Law, a crooked but brilliant financier. At one point, the Mississippi Company was reputed to have a total enterprise value equal to $6.5 trillion today.¹

If Mr. Mckay were writing a follow-up book today, he would have included the stock market crash of 1929 and the Dot Com Bubble of 2000. He might have even quoted Margot Robbie as she explained what Collateralized Debt Obligations were from a bubble bath in The Big Short. Subprime debt fuelled the housing bubble that led to the Great Financial Crisis of 2008. Each of these more recent bubbles caused blue-chip equity prices to drop between 50-80%, and with two of them, the ultimate recovery after fees and inflation took more than a decade. If that same investor was counting on their portfolio to fund their retirement, children’s education, recreational property, or business, they were hooped.

What causes such irrational behaviour in investors whom one would expect to be rational and sophisticated? In the case of Newton (and many others), it was the Fear of Missing Out. At one point, he sold his shares and received 7000 pounds ($1 million USD today), but shortly after, he went back in because his friends were still making money (at least on paper). Newton’s IQ has been estimated to have been around 190, making him one of the smartest human beings in history.² It is extraordinary how a simple emotional response to an investment could have brought down such a towering intellect.

How does this relate to today’s markets? Consider the following:

• Over the past 12 months, the S&P 500 has gained 35%, while the NASDAQ Composite has increased by 34.39%.³
• The S&P 500 Shiller Price-to-Earnings (PE) ratio, trailing ten years adjusted ratio, is at its third-highest level in more than a century, higher than October 1929.

• Even when looking at projected PE ratios, the S&P 500 is expensive and getting quite close to levels reached at the height of the Dot Com Boom. It is trading well over its historical average of 16.6.
• This, in turn, has brought the dividend yield of the S&P 500 to well below its long-term average of 1.9%.

https://www.gurufocus.com/economic_indicators/6061/sp-500-pe-ratio-with-forward-estimate

https://www.gurufocus.com/economic_indicators/150/sp-500-dividend-yield

Other global equity markets are indeed trading at more reasonable levels than the S&P 500, although on September 26, 2024, the Toronto Stock Exchange (TSX) crossed $24,000 – an all-time high. However, the S&P 500 represents about $50 trillion of value, more than 40% of the $115 trillion of all public markets around the world. If we experience a bear market, usually defined as a drop of at least 20%, $10 trillion of wealth (or more) will be realized. What impact would an event like that have on individuals’ retirement or travel plans, education funding for children, business plans for entrepreneurs, and lending practices at banks?

Our clients know that we believe in a broadly diversified portfolio model that emulates some of the major pension plans in Canada, known as the Maple 8, and recognized globally for their effective investment platforms. That means that at any point in time, we would not allocate more than 35% to public equity markets as part of the Nicola Core Model.

That has allowed us to achieve a net return to our clients that is relatively close to a 100% equity portfolio invested in the S&P 500. (See the chart below from our website as of September 27, 2024.) This is a period of almost 25 years. Returns are relatively similar, but the volatility is not, as can be seen in the table below. The Nicola Core Composite return has experienced a maximum drawdown, worst performance from peak to trough, of -11.28% from August 2008 to February 2009 (6 months of decline). It recovered 7 months later by October 2009.

On the other hand, the S&P 500 (in Canadian dollars) experienced a drop that began in August 2000 and did not bottom until February 2009, a 102-month period. It then required 56 months to fully recover its 51.4% drop by October 2013. These results were calculated at the end of 2023.

This analysis assumes that the average investor is going to realize the returns of a particular index or asset pool, that they will invest and hold the asset over long cycles and avoid panic or market timing. That is not the case, and as Dalbar Consulting and Morningstar have shown with many decades of analysis, investors underperform both indices and funds by as much as 2-3% per year because of behavioural traits that lead to irrational decisions.⁴

Effective wealth building is a marathon, not a sprint, and investors have to be careful about being distracted by shiny objects that are the flavour of the current investment world.