Bubbles are
a naturally occurring phenomenon in financial markets. However, while academics
and subscribers to the Efficient Market Hypothesis will argue that a market
inefficiency, such as a bubble, could not exist, practitioners see differently.
After all,
anyone with money at risk in their own account or for clients will say that the
market did not behave rationally during the recent credit bubble in 2007-2008
or the Dot-com bubble in 1999-2000.
Bubbles have
existed for centuries with the most infamous dating back to Tulipmania in the
1600’s in Holland. Human nature and our inherent behavioral biases fuel the rapid rise in asset prices that accompanies
a bubble’s expansion phase. This unsustainable growth in investment leads to an
eventual dramatic decline that happens nearly as fast the popping of a balloon.
While the
peak and end of a bubble are easily identifiable in hindsight, the stages of a
bubble can be further classified into five chronological categories: Displacement,
Credit Creation, Euphoria, Critical Stage/Financial Distress, and Revulsion. James
Montier notes that “Despite the wide range of assets that have witnessed bouts
of irrational exuberance, bubbles seem to follow a similar pattern” (Behavioral
Investing: A Practicioner’s Guide to Applying Behavioral Finance). In other
words, as long as human beings drive the supply and demand for an asset,
bubbles have the possibility to exist.
The start of
a bubble begins with an exogenous shock to the system that creates
displacement. This could result from some invention or political regime change.
The increased profit opportunities in this impacted economic sector will cause the
prices of physical and financial assets to begin to climb. Using an analogy, think
of this stage as the point when you attach a balloon to an inflation device. Air
begins to flow in and it starts to inflate.
Next, the increase
in these particular asset prices is intensified by credit creation. This phase
will cause the banking/financial sector to expand with cheaper credit available
to corporations as well as consumers. Montier notes that as a result of greater
availability and access to loans “Sooner or later demand for the asset will
outpace supply, resulting in a natural response of price increase.” This price
rise becomes self-fulfilling as investors become more aware of the opportunity
and herd money into the rising asset class. Moreover, as the value of
investments rise so will income and wealth which will provide more money for
reinvestment. The bottom line is that this excess liquidity has to find a home
somewhere and historically has ended up in real as well as financial assets. Using
the balloon analogy, this is when it begins to take its bubble-like shape.
Third,
speculation begins to run rampant among all market participants. This state of
euphoria occurs when “speculation for price increase is added to increasing investment
for production and sales.” During this phase new investment products will
emerge that are tailored to meet this excessive investor demand. For example,
during the 1990’s mutual funds that targeted an “aggressive” investor profile
experienced the fastest growth in assets under management. Not only will the
general public be overly optimistic, but analysts and corporations will create
forecasts of unsustainable growth rates. In order to justify these high valuations
new accounting metrics will take the place of old mainstays in order to
accommodate the “new reality.” This is when our balloon is becoming inflated
beyond comfort and stretching its limits.
Fourth,
after a euphoric rise in asset prices and speculation financial distress is
sure to ensue. This critical stage for the markets and economy is initiated by
insiders who take their profits through open market sales or initial public
offerings (IPO’s). Whenever selling by insiders considerably outweighs buying
throughout all industries it is a reliable sign of an impending market top.
Soon after the insiders sell out, a state of financial distress begins to
surface as over-leveraged firms start to realize they may not be able to meet
their liabilities. Montier notes that “As the distress persists, the perception
of crisis increases.” This will encourage investors to withdraw money which is
why an increase in cases of fraud and Ponzi scheme, like the Madoff scandal
during the end of the recent credit bubble, appear during the last phases of a
bubble. At this point the balloon that has been inflated will no longer expand
and has reached its maximum capacity. It may even begin to naturally try to push
some air back out. Simply, the bubble economy cannot grow any more.
Fifth, a
point of revulsion is experienced by market participants. This final stage of
the bubble cycle is characterized by a general disgust for risk and lack of
desire to participate in the markets at all. One word that is commonly used to
describe this state of the markets is capitulation. Montier states that “Capitulation
is the moment in which the final bull admits defeat and throws in the towel.”
This can also be referred to as a degenerate panic that is accompanied by a
dramatic decline in trading volume. Montier adds that “Usually the end of bear
markets is coincident with collapses in volume.” Referencing the balloon
analogy once more, this is the moment at which it pops. The party is over.
Mainstream investors have caught on to the game and want out, fast!
So what
triggers an end to the panic selling and creates a price floor to support
subsequent advances? Based on Montier’s research one of the following three
events must occur in order to create a reversal of trend:
1)
Prices
fall so low that investors are tempted to move back into an asset
2)
Trade
is cut off by setting limits on price declines
3)
The
lender of last resort (e.g. the US Federal Reserve) steps in
Using the
stages of a bubble as described by Montier will provide a helpful framework for
your asset allocation decisions. Additionally, knowing what trends are
developing in markets around the world can help identify new trade ideas even
from a systematic perspective. These ideas can then be validated with your proprietary trading rules.
As always,
please feel free to contact me with any comments or questions. Thanks for
reading.
John
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