Bubbles/Booms and Crashes part 1

 The section is intended to describe larger-scale bubbles / booms and collapses, not individual stocks, bonds, or other investment products. Some of the lessons also apply to individual investing vehicles. I use a bubble when I talk separately about the insane price of an asset class. The boom describes the general euphoric economic conditions.

Almost all bubbles and booms contain too much cheap money, positive emotions, too little fear of losses, moral hazard, an abundance of amateur investors into the market, an euphoric consumer sentiment, a sense of the new age, and positive political factors. Before long, the bubbles burst. This often involves shrinking money supply, negative emotional storms, excessive fear of loss, and the negative effects of political factors. Explaining bubbles, booms, and collapses by individual factors or patterns is absurd but annoyingly common.

Bubbles and booms are causing insanely high prices for different asset classes. Prices can be so high that no one can imagine them. For example, Japanese real estate prices rose tenfold in the 1980s and stock prices 6-7fold at the same time. Common to the booms and bubbles is the increased peak prices much higher than previously expected. Yield expectations become mathematically almost impossible. The insanity can be outlined by calculating what kind of returns should be obtained at current prices, even over the next couple of decades. When you start talking about double-digit percentages that don’t start with one, it’s certain that a boom or bubble won’t last.

Bubbles and booms are about excessive demand compared to supply. In crashes, supply is excessive compared to demand. Price bubbles are more likely to occur in assets where supply is limited or demand is high. One of the former is Bitcoin and one of the latter is commodities. Bubbles, booms and crashes are self-reinforcing events. Both are also impossibilities for mainstream economists. They are explained by external shocks. Bubbles, booms and collapses are not uncommon. There have been many bubbles and booms in the last three decades: the Japanese real estate bubble, the Asian economic boom, the dot-com bubble, the U.S. real estate bubble, and the Chinese real estate bubble.

In the current situation, in January 2022, many can assume that they will also see inflated bond prices or a tech bubble. Bubbles and booms, to my knowledge, have not been mathematically defined by anyone. They have no precise definitions. Their prices are at unsustainable levels, which will fall drastically in the end, causing prices to collapse and major economic damage. This section looks at the extensive bubbles and booms that have a strong impact on the economy and their characteristics. I will briefly review the special features of stock and real estate bubbles later.

Independent thinking is a golden characteristic for the investor. During bubbles, booms and crashes, it is more important. During them, there are more empty suits who come up with at least one credible reason for nonsensical prices or the “end of the world” like “we live in a time of low interest rates.” At the extremes of cycles, mass hysteria causes large losses for investors. At other times, watching large crowds is less dangerous. Medium returns are reasonable and there are no major upheavals threatening investor assets. You must be able to identify mass hysteria by yourself. The content of the book helps with that, but it does not remove the importance of independent thinking.

Psychological profile of financial market cycles

 

Most cycles follow a continuum of the psychological profile in which the majority of market participants experience certain emotions. The continuum according to Wall Street Cheat Sheet from base to base is approximately:

Depression → disbelief → hope → optimism → faith → enthusiasm → euphoria → complacency → anxiety → denial → panic → capitulation → anger → depression

Not all cycles include all stages. Euphoria, panic, and surrender do not occur in all cycles. I did not mention envy, but that is also present. It occurs at all stages. The intensities of emotions vary in different cycles. Not all investments in one asset class face all emotions. This may be self-evident, but it must be mentioned. Investment targets may follow individual psychological profiles. The following description follows the change in psychology as the market wakes up from the previous bottom and moves to the next one.

The depression conquers the market and investing loses its meaning for most of the market participants. The money is gone and there are few professionals left. The previously great investment has left a disgusting thought: “investment xyz, no way!” The loss of excitement about the markets seizes the professionals too. Enthusiasm has become non-existent and hope is lost. P / E figures are low. Prices move a little. They can stay in this mood for years. The greater the euphoria or investment folly, the more depressed the market is on average. Even the depressed market can rise slowly. Most people do not detect the rise and most do not have any thoughts about it. There will be no significant changes in share prices and the stock chart will look almost flat.

The depression in the market will not remain forever. The slope of the rise will start to increase. The market experiences an awakening and an ascent in the market goes up fast. The general public believes in a momentary relief in the market. "The fool's rally on, yes, they will find out that this was just a temporary bounce." The result is a short rally that ends with the repatriation of the profits of the professionals.

The decline is short and prices are rising. The hope of a larger audience begins to awaken and the slope upwards increases. The hope of a price recovery begins to live in the minds of investors. They see the higher probability of ascension and improvement in the market. The eagerness of some of the general public to return to the market rises. There are fewer gloomy ideas about investing. The general public shines with their absence.

After some time of hope, optimism in the market wakes up. The market outlook tells that the price rise will run many years from now and there will be a great possibility to benefit from it. As optimism wakes up, the upward slope steepens. The situation looks good on a broad market. Investing is not just a professional activity. With optimism, it is safe to place your bets and the peak is at a safe distance.

As optimism grows, investors have put most of their money on the broad market. Prices are rising fast and faith in the market is high. It's easy to say, "Now I'm putting it all in and enjoying the price increase." Some are getting rich and large longer-term bills are not immediately known. Borrowing is not a significant factor because the general public has not experienced a long enough rise.

With all of your own money in the market, few investors will lose their money and prices will go up. Enthusiasm is widespread and there is no fear of tomorrow. The general public believes that it is safe to borrow money for investment because it is easy to offset interest rates on loans with profits. The prevailing thoughts: “We have to spread the delightful message of easy profits to everybody we know because they need to get rich too!”

The euphoria of the ascension phase does not always occur. It occurs on a large scale a few times in a person’s lifetime. Few believe that they can lose money. The general public believes everyone will get rich. The prevailing thoughts are, “I’m a genius,” “I will make more money I can spend,” “I don’t have to work.” When Euphoria strikes, many professionals believe that the general public will lose their money, but they return to the market to make money with the last euphoric price movement. When real euphoria strikes, many prices will rise by hundreds of percent in a few years and no one is afraid of losing. The slope of the ascent is the steepest. Stock market listings, their huge volumes and significant price increases on the first day of are the clearest signs of euphoria.

Eventually, the euphoria slowly subsides step by step until suddenly the prices fall rapidly down a few tens of a percent until they bounce up. Prices do not reach the old peaks. Complacency strikes market participants. They expect another massive rise that will not come. The prevailing thoughts are, "Yes, the market is still rising because people are as wise as I am." "Others are still making a lot of money." Instead of a significant rise, the market is fluctuating without moving. This can take several months and there are no big signs of a decline.

Market psychology is slowly changing in a more negative direction because the upward trend is no longer working well. Complacency and faith in new great investment opportunities will disappear and a faster decline towards the bottom will begin. Anxiety strikes. The prevailing thought is, "Why did the bank's approval of my guarantees vanish?"

The situation continues to deteriorate and people are on denial. The decline is only accelerating. Disbelief that the market will no longer properly rise has more power. The prevailing thoughts are: "Fortunately, I chose brilliant investments, which cannot decline anymore, others realize their goodness." The market may still get a little excited and rise.

Eventually, panic strikes and prices fall rapidly. The daily changes are large and the prices of better investments also fall fast. If you have to sell, you can only sell the good stuff. The majority believe it is better to sell before they lose all their money. The prevailing thoughts are, “I have to sell my assets before others” or “Now I must sell so I will not lose everything.” There is not always a panic. Sometimes it takes a few days or weeks before it ends. Wide fronts of double-digit decline rates are normal in panic. No contingency attempts are working. Prices fall as soon as the stock market opens and stop-loss regulations are not low enough.

After a possible severe panic, there is often still a capitulation ahead. The hope of the majority is gone. The prevailing thoughts: "Everything will be lost, why should I care about my assets anymore?" or "I will never invest again." This phase signifies the last possible major downturn before the bottoms. During it, it is safe to return to the market without borrowed money. It is less common than panic.

After a possible capitulation, anger strikes: "Why didn't xyz's CEO X tell the truth that the high return expectations were not justified," "Why do the financial authorities allow the sale of these products?" Scapegoats for losses are found also from short sellers or a neighbor Joe who gave bad advice to invest in an asset where ”everyone makes much money.” Anger towards CEOs and people recommending shares for their profession is often justified. They almost always survive and often get bonuses on top of the deal, unlike their customers. The rationality of anger is another matter.

In the end, the market is depressed. They don't interest anyone. This is the best stage to buy, but few can do it. The vast majority are stuck in negative thoughts: "What a fool I was, now my pension is gone and I'm going to have a poor pension.", "My situation will never improve!" The severity and duration of the depression in the markets depend on the length and strength of the ascension and the emotions connected to it. The next rise is around the corner and the most likely option is a new peak at its end.

How can an individual perceive the psyche of the market? There are clues in the market, but there are so many participants that the collective atmosphere is not easy to notice. The first clues can be found by observing yourself. Are the above thoughts present? Which ones are the strongest? Which of them are most common? You can also follow people who do not usually invest. Are they suddenly excited about investing in your immediate circle or is anyone interested? If you don’t know then ask people if they are interested in investing. Go through a larger crowd if you can.

Follow the media. Are there any headlines in the afternoon papers about investing or special investments? What do the headlines say? Are they positive or negative? Observe how often they are published. Try to find studies that tell you what the average return expectations investors have. The higher the expectations, the more likely euphoria is to strike. The lower the expectations, the more likely the market is to be and stay depressed.

Markets are fluctuating more than they should. The aforementioned emotional turmoil moves them upside down. The best moments of buying and selling are created according to the strongest fluctuations in emotional life of the market. Those who disagree with the excess fluctuations have the probabilities on their side. That doesn’t mean they’re right. It’s good to be outside of the worst emotional turmoil.

PS. You can also find a psychological profile of financial cycles from here