The Boom and the Bust

In Chapter 28, Larry Harris looks at the scariest moments in financial history: Bubbles and Crashes. These aren’t just “volatility”; they are moments where the relationship between price and reality completely breaks down.

The Anatomy of a Bubble

Bubbles usually follow a predictable pattern:

1. The New Story: A new technology (Radio in 1929, the Internet in 1999) or a new resource is discovered.
2. Over-Optimism: Uninformed buyers get excited. They ignore the math and focus on the “potential.”
3. The Momentum Wave: As the price rises, Momentum Traders jump in. They don’t care about the tech; they just want to sell to the next “greater fool” for a profit.
4. The Price Accelerator: As the price goes up, the buyers get wealthier (allowing them to buy even more) and the short-sellers get margin-called (forcing them to buy to cover). Everyone is buying, and the price goes vertical.

Why Value Traders Can’t Stop It

You’d think the “smart money” would sell and stop the bubble. But they often can’t.

• Lack of Capital: If you short a bubble too early, you might go bankrupt before the crash happens.
• The “Rational” Fear: Value traders start to wonder if they are the crazy ones. “Maybe I’m missing something? Everyone else seems so sure.”

Anatomy of a Crash

Crashes are usually faster and more violent than bubbles.

• The Trigger: A tiny piece of bad news arrives. In 1989, it was a failed bank deal for United Airlines.
• The Cascade: The price drop triggers Stop-Loss Orders and Margin Calls. This creates a wave of forced selling.
• The Panic: When buyers see the price plummeting, they pull their orders. There is no “depth” left in the market. The price has to drop 10% or 20% just to find someone—anyone—willing to take the other side.

Historical Meltdowns

• 1929: Fueled by massive debt (margin) and the excitement over Radio tech. It took 25 years for the market to recover its previous high.
• 1987: The “Portfolio Insurance” crash. Institutional investors had programmed their computers to sell automatically if the market dropped. When it did, the computers all tried to sell at once, causing a 23% drop in a single day.
• The 1989 Mini-Crash: A low-liquidity “Indian Summer” day where a few sellers overwhelmed a market that had already gone home for the weekend.

Summary: Reversion to the Mean

Most crashes aren’t “market failures.” They are corrections. They bring the price back to fundamental value after a bubble has pushed it too high. The pain is real, but the resulting price is usually more “informative” than the bubble price was.

In the next part, we’ll look at the tools regulators use to stop the bleeding: Circuit Breakers and Trading Halts.

Next Post: Circuit Breakers and the Politics of Volatility (Part 2)