by Wolf Richter, Wolf Street:

The phenomenon works – until it doesn’t. What’s astonishing is how long it works.

This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:

There is a phenomenon in stock markets, in bond markets, in housing markets, in cryptocurrency markets, and in other markets where people attempt to get rich. It’s when everyone is pulling in the same direction, energetically hyping everything, willfully swallowing any propaganda or outright falsehood, and not just nibbling on it, but swallowing it hook, line, and sinker, and strenuously avoiding exposure to any fundamental reality. For only one reason: to make more money.

People do it because it works. Trading algos are written to replicate it, because it works.

It works on the simple principle: If everyone believes stocks will go up, no matter what the current price or the current situation, or current fundamental data, then stocks will go up. They will go up because there is a lot of buying pressure because everyone believes that everyone believes that prices will go up, and so they bid up prices and chase stocks higher.

I call this phenomenon “consensual hallucination” – “consensual” because everyone eagerly smokes the same stuff in order to be able to get the same hallucinations everyone else is having, and to be part of the movement, because they believe that this movement will make them rich, and if enough people have this consensual hallucination, and if algos are programmed to trade with it, then it works wonderfully.

Until it doesn’t. The moment it doesn’t is when this hallucination begins to fade. And what happens then?

One of the most fascinating places were consensual hallucination is beautifully at work – until it isn’t – is in the entire cryptocurrency space. At first there was just bitcoin. Then more people invented their own cryptos and started selling them to others for real money. By now there are 2,350 cryptos listed on coinmarketcap.com. Everyone can create their own cryptos and attempt to sell them.

But in order to sell them and push up prices and make money, the creators have to get enough people together that eagerly transition into this consensual hallucination – the feeling that everyone is pulling in the same direction, and that this thing is going to go up and make everyone rich if everyone believes that everyone believes that it will make everyone rich.

There is no fundamental basis for any of these 2,350-plus cryptos to have any value above zero, from bitcoin on down.

But as the folks in the crypto space have found out, this consensual hallucination can suddenly wane, as enough folks are starting to cash out because they no longer believe that everyone believes that this thing will go up further. And suddenly, once they come out of this consensual hallucination, they worry that this sucker is going down. And they try to get out.

This is when prices begin to decline, or plunge, and these dropping prices pull more people out of their hallucinations with a sort of rude awakening, and they sell in order to hang on to what they still have left, and this pushes prices down further and yanks more people out of their consensual hallucinations.

It works wonderfully on the way up, and it can last a lot longer and be a lot more powerful than folks who haven’t smoked the same stuff think possible. But at some point, it turns into a treacherous and gut-wrenching mass-awakening.

To pinpoint when consensual hallucination begins to fade and more people come out from under it is the hardest thing in the world. Since consensual hallucination is by definition not rational, there is no particular rational cause, by definition, for it to end.

But consensual hallucination is not permanent. And it ends. It might be an extreme event that shakes people out of it, such as a severe recession or a financial crisis. Or it might be something more mundane, such as the perception that now is a good time to sell that then begins to spread.

If rational reasons had been allowed to rule those prices, they would have stopped rising a lot sooner. And some things, such as cryptos, would have withered on the vine.

At some point, people do come out from under this consensual hallucination. This can happen very gradually and unevenly, or suddenly and all at once. History is full of both events. And often it’s a combination, at first gradually and then suddenly, or vice versa.

The world is full of stock markets where this has happened:

Read More @ WolfStreet.com