May 22, 2002


The best protection against future Enrons isn't more regulation, it's educating investors about the nature of speculative bubbles

Wynn Quon

Will more regulation prevent another Enron? Would more barbed wire on the Maginot line have stopped the German blitzkrieg in 1940? The biggest problem with the talk of new regulation is that it doesn't recognize that Enron was the result of a speculative mania. These rare episodes of financial euphoria are different from your average run-of-the-mill stock market activity. They are powerful enough to overcome any regulatory controls or barriers. The best protection against future Enrons isn't more rules; it's educating investors about the nature of speculative bubbles.

This is not to say that regulations are useless. They work well in normal markets. It's just that 1999-2000 was about as far from normality as you can get. Enron was headed by ruthless MBAs who stood to reap hundreds of millions of dollars for breaking the rules. The money came from profit-hungry investors who indiscriminately showered New Economy companies with mountains of cash. No regulation can withstand the corruptive assault of indescribable wealth.

In a bubble, not only do the ruthless bend the rules; the rest of us are willing to go along. The Fastows and Skillings at Enron should certainly pay dearly for their sins. But to claim that everyone else was an innocent victim doesn't ring true. Arrogance and greed were not limited to the boardrooms at Enron. Take the oft-cited Enron employees who had all of their retirement assets in Enron stock, for example. What were they thinking? The ugly truth is that no one was willing to ask questions as long as the money kept coming. That famous financial innovator, Charles Ponzi, said it best: When our vision is fixed on one thing, we might as well be blind. Sadly, there's no legislation known to restore vision to the sightless.

Many of the ideas for new regulations are coming from academia, which is ironic, because academia itself shares indirect blame for the fiasco. Why? Look no further than the textbooks used in the business schools across North America. Two of the more popular ones have the same title: Investments. One is written by Bodie, Kane and Marcus, the other by Sharpe, Alexander, Bailey and Fowler. Neither mentions stock market bubbles. That's like having a meteorology textbook that doesn't mention hurricanes.

If business schools don't equip financial advisers with even basic knowledge of the nature of speculative manias, what hope is there for the common investor? When the NASDAQ hit 5000, the warnings in the media often boiled down to vague references to Tulipmania. Missing were these facts:

- When bubbles collapse, they do so at great speed. Many tech investors, even those who suspected the good times wouldn't last, were surprised at how fast things turned bad. But this has always been true. The South Sea bubble, one of the classic cases of speculative excess, collapsed over a period of less than six months when prices fell 80%. The Japanese stock market bubble ended in 1990 when the Nikkei 225 dropped 50% in a year. The Tech Bubble of 2000 fits right in with a decline of 65% over a year.

- Financial wrongdoing and speculative manias go hand in hand. In John Galbraith's brilliant account of the Great Crash of 1929, he coined the lighthearted term "bezzle" for the amount of undiscovered fraud in a booming economy. The bezzle always grows when times are good because people are too busy making money to pay attention to accounting. When the crunch comes, the bezzle gets exposed. Or as Warren Buffet puts it, the tide goes out and we find out who's been swimming naked. The Enron scandal has an eerie resonance for anyone who's read Galbraith's book. That's because one of the most spectacular bankruptcies after the 1929 Crash was that of MidWest Utilities which, like Enron, was a power company with an unhealthy appetite for off-balance sheet activities.

- The engine behind every bubble is the massive use of borrowed money. Ordinary folks buy stocks on margin, and companies issue debt for acquisitions (Tyco), or buildout (Global Crossing), or just to juice up their balance sheets (Enron). It is this overleveraging that guarantees eventual collapse.

- Bubbles are mass psychological events. That's the difference between it and a "normally" operating market. It's a fuzzy definition, but the work in the new field of behavioural finance may eventually put it on more solid ground. At the very least, we now have names for the types of psychological myopia at work during a speculative episode. "Recency" is the tendency for people to put too much weight on recent events in predicting the future. In 2000, for example, many investors expected double-digit returns to continue indefinitely. "Anchoring" is when we fixate on numbers without a rational basis. When the NASDAQ crossed 3000, there were warnings that prices had gotten too expensive, but once the index had crossed the 4000 and then 5000 marks, the 3000 level was suddenly viewed as "cheap." "Confirmation bias" happens when we filter out bad news that doesn't fit our view of the world. It explains why the Mary Meekers and the John Roths just didn't see the crash coming.

- Despite the psychological roots of a bubble, there are quantitative measures of overspeculation. P/E ratios and price-to-sales ratios go off the scale, and stock turnover increases dramatically. All of these developments have been statistically linked to subsequent underperformance in the stock market.

Incidentally, there are two things that the history of bubbles would predict for the near future. The first is the collapse of one or more prominent mutual funds. The second is a prolonged period of economic malaise as previously exuberant investors and corporations default on their debt. Particularly hard hit are those who overindulged when the party was in full swing. Those hoping for Nortel to hit the $120 mark again are in for a wait of a decade or more.

Back to the issue of regulation. One obvious question is this: Doesn't a market that is prone to mass psychological events require the government to step in to maintain rationality? The answer is no, because government officials are as easily swayed to exuberance as the rest of us. On March 2, 2000, Finance Minister Paul Martin announced that there wouldn't be any more deep recessions for the next 20 years because of the "cascading of new technologies." There's no better illustration of mass psychology at work, because only seven days later, on March 9, the NASDAQ hit its all time high of 5132. The next day it would begin the meltdown plunge that would wipe out trillions of dollars of shareholder wealth.

Wynn Quon is chief technology analyst at Legado Associates ( E-mail:; Part of a Series