The result was the second act of the play, a stock rebound that made up about half of the losses from the initial plunge.
Up to that point the behavior of stock prices generally made sense. But then came the third act, a surge in prices that eliminated most of the previous losses and drove the Nasdaq to a new high. And this surge bore all the usual signs of a bubble.
Robert Shiller, the world’s leading expert on such things, has pointed out that asset bubbles are, in effect, naturally occurring Ponzi schemes. Early investors see big gains because later investors drive prices up, inducing more people to buy in, and so on; the party continues until something cuts off the flow of new money, and suddenly everything crashes.
So it was with the recent stock surge. Encouraged by the Fed-induced recovery of stocks from their March lows, some investors began buying. Their optimism became a self-fulfilling prophecy, as initial gains led more cautious investors to join in, driven by FOMO — fear of missing out. It looked a lot like the dot-com bubble of the 1990s, except on a vastly accelerated timetable.
Although there is some dispute about how important they were, most of the evidence suggests that a major role in this apparent bubble was played by small investors — “retail bros” — pursuing get-rich-quick dreams. Some of these exuberant investors were people who normally bet on sports and were looking for an alternative source of excitement. And as the Hertz example shows, they didn’t care much about quality.
Why didn’t large investors offset this apparent irrational exuberance by selling stocks? As John Maynard Keynes argued long ago, staid investors who usually stabilize the market tend to abdicate judgment in “abnormal times.” We are, you might say, in a time when the smart money lacks all conviction, while the dumb money is filled with a passionate intensity.
And now the bubble may — may — be bursting. But does any of this matter?
In a direct sense, not much. Stock prices surely have some impact on business investment and consumer spending, but these effects are probably small.