Bubbles, Booms and Crashes part 6. Indicators

 Previously, I listed a few signs of booms such as reflexivity, money supply growth, psychological phenomena, and political factors without their more specific signs or indicators. It should be clarified how the indicators are reflected in national economies and in the prices of investment products. In numerical signals, the rate of change is important. In them, a longer-term decelerating pace of change anticipates a slowdown in bubbles, booms, which lead to crashes. There is no single sign or indicator that predicts the progression. The more characteristics you can find the better you know what you see.

Reflexivity has signs. One is to move further and further away from the average historical return. For example, stocks can be examined in comparison to the trend of ten-year average earnings per share, which has been around 17. The farther one moves from that figure, the more reflexivity is affected. As growth slows, reflexivity decreases. The interest rate of government bonds must be scrutinized because it makes more sense to pay higher prices for shares when it is low. The prices of houses or other share classes can be compared to the average trend growth for the reasons mentioned earlier.

The former is not the only sign. Declining interest rates and the fact that borrowing is based more on collateral values ​​than income are indicative of reflexivity. The first increases the chances of reflexivity and the higher leverage it requires. Higher prices combined with higher leverage increase the likelihood of reflexivity. The latter is an early signal that anticipates reflexivity. Lower collateral requirements and increases in collateral values ​​increase the probability of reflexivity and strengthen it.

In smaller countries, a significant rise in the amount of external money flows and the strengthening of the local currency signal reflexivity. So do loans to locals in foreign currencies. When foreign money notices the higher-than-normal returns offered by the local country, it rushes to the local market. Local incomes are rising and the currency is strengthening further, making the local market more attractive.

Reflexivity works in both directions. The previous phenomena also work in crashes, but they increase the decline in prices. They fall below average trends, increasing the decline, as interest rates rise, prices fall, and declining collateral levels increase borrowers’ willingness to increase collateral requirements. The transition from collateral requirements to income requirements will lower prices as revenue declines. The transfer of foreign currency away from local markets lowers prices, lowering the value of the currency, reducing the value of collateral previously issued, which also affects prices.

Several figures and indices can be examined to notice reflexivity. Changes in the supply of money tell something about it. Different countries have their own statistics. Not everyone is as reliable, but at least the US and eurozone money supplies can be tracked. There are also indices around the world to describe indebtedness opportunities such as the MBA Mortgage Index in the US, the address of the website can be found in the sources. The longer the maturity of the loans offered, the more certain the reflexivity will affect. Long 100-year mortgages or government bonds are a signal. The historically high volume of loans in the stock market compared to the indices indicates possible reflexivity.

Psychological factors are present in bubbles, booms and crashes. Let’s start with social proof and state that at its highest it applies to almost everyone. Everyone in their immediate circle is starting to have one or more people who are quickly enriched with popular investment products or have invested large sums in them, with at least a large amount of assets on paper. They are also eager to recommend their investments to others and say they are stupid if they don’t do the same. The more close colleagues or friends report on their successes and hundreds of percent returns in the short term, the closer the boom and the end of it is. The collapse has begun when the same people don’t say a word about investing or their losses. Social proof is mostly caused by amateur investors.

The progress of social proof can be monitored in Google Trends. There you can see how popular certain keywords have been at any given time. Peak moments don’t directly correlate with prices, but the highest search volumes are in the vicinity of both peaks and bottoms within a few months. The latter may be even better correlated.

Be fast! Buy before it becomes too expensive! The feeling of scarcity and hurry is one sign of a boom. Quick jumps in housing prices or multiple oversubscriptions of investment products indicate a shortage of supply or a sense of it. Low number of shares available in IPOs may be a conscious choice for listed companies. Two- or three-digit percentage increases in listed products on first trading days indicate scarcity. In the crash the supply of stocks is plentiful. This is reflected in the rapid decline. For example, a broad front before popular stocks lowers its prices in double digits on several days.

The majority of people follow a few authorities that seem credible. The latter may have been in other businesses before the bubble or boom. The general public gets promises from them where prices multiply fast. As the boom progresses, the promises increase. They sound nonsensical to those familiar with things. As the bubbles and booms progress, the warnings of the former follow, the anti-authorities of the booms, increase. At the same time, more people believe they are incomprehensible. In crashes, authorities and their promises are revealed to be either scams or their views wrong. During that time, the “Warren Buffets” will also start to get rich with their foreclosed assets. Their returns exceed averages by significant margins as the collapse progresses.

Excessive regard in one’s own abilities, possessions, and chances of success is reflected in excessive trust in both communities and individuals. The euphoria created by booms and bubbles increases confidence in significant and rapid economic growth. It can be seen e.g. as large-scale, absurd consumption patterns. Record prices are paid at auctions. You can see signs like the construction of the world’s tallest building or record-breaking massive construction projects that exceed their budgets. A sign of bust may be the interruptions in them.

It is particularly evident in individuals who, during the new economy, have earned significant returns, at least on paper, through either their investments or their business. They buy expensive cars and waste their money on status symbols. The phenomenon does not only affect individuals. One sign of the new economy is found in individuals who leave their jobs because they believe they can be investment professionals. They recommend the same to others. This “This time it is different” delusion is big.

The above factors reinforce the illusion of excess availability, but they are not all the causes for its existence. The media is a significant part of the strengthening. They give their followers what they want to hear during a boom. They want to hear that ”now is a good chance to get rich immediately,” etc. They dig up people who suddenly became rich and let them present their advice. It is common that the majority of journalists don’t understand enough to be able to question bad advice. They lift the wrong authorities on pedestals and write negative stories about how those who have invested for decades have lost their grip. They talk about how their investments don’t match short-term successes. The number of things moving from media placement is at its peak at the end of the boom or the start of the collapse. At the same time, their availability and popularity are at their highest.

There are many signs of political factors reinforcing bubbles and booms. One is tax cuts on certain investment products or real estate. Bubbles and booms may gain significant start-up momentum or accelerate as wealth is diverted to tax-advantageous destinations. Speeches by politicians and central bankers about the merits of a booming economy run rampant. Some of them may warn the public. Unfortunately, they do not lead to actions when they are important.

Promises to save investors are a sign of the moral hazard that has occurred in all booms. Promises ultimately lead to actions. Unfortunately, they are too late. The first capital injections for those who mismanaged their business are a sign of moral hazard and anticipate a boom in artificial respiration for too long. At the same time, the probability of a larger collapse increases.

The increase in the use of “alphabet soup” or other new investment products in language is a sign of a boom. Increasing supply to retail investors also speaks for itself. Their complexity can also tell about it. The more investment products you don’t understand, the more surely the bubble is growing. The deregulation is also a sign of a boom. Increasing them probably indicates the risks that have already materialized. Regulators are often late.

The interference of central bankers or politicians in market price formation are signs of bubbles, booms, and crashes. Purchases or price cuts by central bankers of investment products will increase bubbles and booms. Unexpected sales or price increases can signal or cause a risk of collapse. The boom can also be seen in the lack of supply regulated by politicians. For example, land use restrictions can tell about a real estate bubble. The rapid increase in supply indicates that the crash is approaching.

There are enough signals about the existence of bubbles, booms and crashes. Alone, they don’t tell much. Certain signals have been present in all the booms and collapses of recent decades: the shift from income-based to collateral-based lending, cheap money and the money supply it increases. Other signals are less relevant, but the more of them are found the more likely booms and collapses are present.

Crash signals are less important because they occur afterwards. They don’t help with timing of sales, but they tell about the likelihood of new investments making sense. The most important of these is the extensive and rapid price cuts of tens of percent. After that, you can start to invest carefully. In addition, “just crazy to invest now” and all the other post-panic messages on the psychological profile after the aforementioned collapses are signals of better investment moments.

Bubbles, Booms and Crashes part 5. Their exponential growth and long-term effects

The growth of social epidemics like bubbles is exponential and nothing happens overnight. They can last from days to decades. Unlimited growth has a certain profile to which four parts can be attached: the slow onset of low exponents, the rapid rise of high exponents, the peaking of rising exponents, and the decline. The first profile is clearest when not restricted or regulated. The profile changes with restrictions and regulations. Exponential growth in stock or house prices are difficult to monitor because each has a different impact on epidemics. Therefore, it makes more sense to follow the exponential changes in other figures such as money supply.

Social epidemics rarely grow steadily. They do not follow a normal distribution and their growth cannot be predicted, although claims to the contrary are normal. The exponents vary at different time intervals. They can take a backseat even if the general direction is upwards. There may be variations in the exponents due to the time of measurement. For example, the weekly variations in the current Covid-19 pandemic are so great that it is not worth looking at daily exponents but at weekly readings.

One of the most important things to monitor is the change in exponential growth. In other words, the progression of epidemics can be monitored by observing exponential changes at regular intervals. A significant slowdown in growth is a sign that the epidemic is fading. This cannot be seen from the individual figures. Sometimes epidemics end in single exponential peaks. The following fictional exponents tell of acceleration first and then decline:

1.0, .1.1, 1.3, 1.6, 2.2, 3.2, 3.8, 4.2, 4.3, 4.0, 3.2, 2.4, 1.3, 1.1, 0.9, 0.7...

In the first phase of an epidemic, the exponent is often a little over one for a long time and does not change much before collapsing or moving on to the next phase. Most of the epidemics are not progressing further. The second phase distinguishes the most contagious epidemics from others. Initially, exponential growth accelerates. It is significant and ongoing. At the same time, the critical mass of the epidemic is reached, that is, it becomes unstoppable for a moment. The exponent is often the largest after that moment and may decrease momentarily before turning back up. The trend continues until there is a gradual decrease or a short steep peak with a potentially record exponent. The former is the most likely option when the epidemic is contained and the latter when it is not affected. The peak is followed by a decline, which in most cases is on average steeper than an increase in economic epidemics.

Long-term effects

Bubbles, booms and crashes have long-term effects. The true nature and duration of the resulting collapse is impossible to assess in advance. One significant factor is how banks operate during a bubble and/or a boom. The second is the source of the money. In addition, the actions of central banks and other regulators are significant factors. In the best case, the collapse will be cleared quickly and in the worst, the consequences will be visible for decades. The more bubbles in different asset classes, the longer the footprint. Declines can be short if not all investments instruments are expensive. Therefore, the dot-com boom of the 21st century did not leave large traces in the U.S. economy as bonds and real estate were affordable.

The devastation of the banking crises caused by the big bubbles and/or booms is awful. House prices will fall by an average of 35%, stock prices by an average of 55%, GDP by an average of 9% over the next two years and unemployment will rise by an average of 7% over the next four years. Without banking crises, the devastation will be smaller on a larger scale, although stock markets, for example, may fall more. The problems without the banking crises can be repaired in a few years. The flight of foreign capital exacerbates problems if it has played a significant role. Roughly speaking, the smaller the local market, the greater the devastation that may result from the outflow of foreign capital.

The aftermath of the Japanese boom tells the harsh language of the consequences. Individual investors may never overcome their losses. The Nikkei index has not reached its previous peak of more than 30 years ago. Property prices also peaked decades ago. Even long-term index investing is not worth it when the boom overheats. The aftermath of the Japanese boom is an example of the crash of simultaneous stock and real estate booms. Not all countries will recover even in several decades. The consequences can be complete changes in societal structures such as the transition from market economies to planned ones.

Bubbles, Booms and Crashes part 4. Political factors

Political factors may include more than just politicians. These include e.g. society's attitudes towards property, other regulators and price formation mechanisms. By the first, I mean whether individual citizens or businesses have a right to their property. In socialist states, it is almost impossible for bubbles and booms to occur because the state owns everything. They may have distorted supply and demand imbalances in the form of high prices or shortages. When the state sets prices, no bubbles or booms arise. In other words, the right to private property is essential for bubbles, booms and crashes.

Politicians can decide to socialize or liberalize property rights. They can also decide how much of the revenue generated by private citizens and businesses will receive by deciding on tax rates or seizures and exemptions of property. Increasing ownership or revenue for individuals and businesses can be drivers of bubbles and booms. Reducing them can cause crashes. The former concern not only the rights of domestic operators but also foreign ones. Opportunities for action can be limited e.g. customs duties.

Politicians can decide on other regulations, such as bank solvency requirements. In addition, they decide on government indebtedness which can increase or decrease the likelihood of bubbles, booms, and collapses. More on that later. Politicians are also responsible for managing state-owned companies, facilitating, impeding or closing down private companies. The above reinforces extremes. They are rarely the decisive reasons for their emergence. They are more common as boom reinforcers, but are less used during bubbles.

Law-deciding politicians, central bankers, and other regulators are also responsible for the moral hazard strengthening bubbles and booms, with risk-takers reaping the greatest benefits while taxpayers offsetting much of the losses. The amount of insanity can multiply due to moral hazard. This can be seen e.g. guarantees provided by state-owned companies, compensation for capital required by bank losses, and other business support during collapses.

In addition, central bankers can increase money supply to support businesses or reduce their debt service costs to help businesses survive bankruptcies. For example, it is reasonable to see Alan Greenspan, initiating the current moral hazard in the United States, announcing his readiness to lower the cost of debt management for investors in the 1987 stock market crash. Since then, rescuing investors has been one of the Fed’s most significant ways to keep financial markets working. At the same time, moral decay has been created.

The role of regulators is reflected in the failure to control new investment products in bubbles and booms. New investment products increase the amount of money on the market, hiding risks. They must prevent the risks posed by complex investment products from being passed on from sellers to buyers and kept so small that they do not pose a risk to the financial markets as large losses. Complex products contain thousands of pages of information and figures. Regulators do not always know their content or risks. In other words, regulators should actually make sure that not a lot of them are put on the market. Unfortunately, this does not happen during booms except in exceptional cases.

The role of central banks in setting the price of money through changes in money supply and interest rates is undeniable, although banks can change their margins when lending money forward. There is no cheap money without low central bank interest rates or the “rumble” of the printing press. Controlling the price of money can have surprising consequences, as banks, companies that borrow money from them, and consumers can misinterpret price signals, making bubbles, booms, and crashes more likely to occur. The worst part is that they have no part in the models that central bankers use to decide the price of money.

Bubbles, Booms and Crashes part 3. Psychology

 Bubbles, booms and collapses are social epidemics and follow their principles. Epidemics have three components: the right people, the right message, and the right environment. They are influenced by several psychological factors such as social proof, authorities, scarcity principle, excess self-regard, and the illusion of availability. They increase both the attractiveness of the message and the effects of the environment on bubbles, booms and collapses. Different people have different effects on both individuals and large crowds.

The messages from the bubbles and booms are simple and engaging. They say everyone gets rich easily and quickly without much effort as long as they invest in new ideas. The message includes attractive predictions of a rise in the pattern “Bitcoin rises to $ 500,000 (now about $ 40,000)” “This time it’s different” is another message available in large-scale bubbles and booms. They often also contain a message of a carefree tomorrow and the prosperity of the nation. The message often has some truth in it, but its significance is exaggerated. The realization of the message is often far in the future, even though the masses believe in sudden enrichment and rapid change. One message is that those who do not participate in the boom are stupid.

Bubbles, booms, and crashes will not occur without massive social proof in which herd behavior is rampant. During booms, it produces a desire to buy the same investments or consume like large crowds. Crashes create a desire to sell and reduce consumption while others do the same. In them, many have to do so because they do not have enough money to consume. Roughly speaking, the closer and more people produce social proof, the more confident the individual becomes and acts like others.

Even large numbers of people can be made to act like a small number of people as long as the latter has credibility. People have an inherent belief in authority. In bubbles and booms, a small number of lucky fools can make millions while believing in the goodness of nonsensical investments because they have happened to succeed fabulously for a short time. Usually these ”authorities” tell the general public what they want to hear. They can get rewards from people like them or the media. In addition, the masses are demanding so-called anti-authorities who tell them they are wrong. They are most often people who have been enriched by the old rules and have not agreed to pay the prices produced by the bubble or boom. They are considered losers during bubbles and booms.

The scarcity principle means that the less a person has something or the harder it is to obtain it, the higher the value. In addition, it works in the other direction. The bubbles and booms in some investments have a shortage of supply relative to demand. Large-scale bubbles are mainly affected by the other side of the coin, i.e. the fact that money moves fast and enriches a large crowd. The above raises both the prices of investments and increases absurd consumption. At the same time, the real economy is growing strongly which raises the above. Too much money significantly increases stupid investment and consumption decisions.

The excessive self-regard manifests itself as excessive faith to one’s own beliefs, qualities, skills, and possessions. Faith of an increasing mass of investors strengthens with the bubble or boom to the heights rarely seen, which raises the prices of “hot” investments. At the same time, larger and larger sums of money find the above items. Faith is not even shaken by failures or losses. They are explained by bad luck or some other absurd reason, and in the worst case, the ego is further inflated. Losses and failures increase the need for investors to look for sources of information that emphasize their own beliefs and skills. One major factor in the bubbles and booms is that investments become more valuable in price as soon as they are purchased.

The excessive self-regard also increases booms and bubbles, with big money portfolio managers acting as one of the reinforcing factors. One of the truths of their work is this: "It's better to lose money like others than to do something different." Many of them protect their own jobs. This is reflected in the so-called hidden indexation of funds, where the investments of the active portfolio manager resemble the benchmark index, differing slightly from it. This also applies to other moments, but the phenomenon is at its strongest in booms due to reflexivity.

The overemphasis on egos is not limited to investors. It manifests itself in central bankers and other regulators. The majority of central bankers have had a long career believing in the theories they have learned and the models they have used. They work well most of the time while increasing regulators’ confidence in them and themselves. The performance of theories and models in the short term increases the excesses of bubbles and booms as well as the devastation resulting from crashes. It is important to ask whether the actions of central bankers and the models they use have a positive net effect?

The illusion of availability means that people give more value to stimuli that are better available. Availability can be both an external and an internal stimulus. It can be improved by an increase in the number of stimuli, recency, or characteristics. Examples of the latter are surprise, novelty, ambiguity, and threat. The illusion of availability is reinforced by the media reporting on fortunate individuals who quickly enriched and took advantage of the new message. The media is full of half-truths or misunderstandings about the basic principles of investing. The illusion of availability is at its strongest when a bubble or boom reaches euphoria. It is also strengthened by other psychological factors.

Avoiding the negative effects of the psychological factors of bubbles, booms, and collapses is not easy. There are a few good rules of thumb to reduce the effects. When you find that a security or asset class is more popular in your immediate circle than others, it is a likely sign of bubble prices. Combining the former with a new economy or investment vehicle should be seen as a bigger alarm signal. Never believe words that contain the message, “It’s different now,” whoever tells you so.

Don’t listen to people who do not have a proven track-record of investing at least a decade above the market average talking about future returns or losses, or who promise high double-digit returns on investment, even in the medium term. Their numbers in public will increase during booms and bubbles. At the same time, the number of people who are wrong is growing. During booms and bubbles, it is even more important to listen to people who have done better than average for several decades. The same is true during a crash. Also, don’t believe people who predict the “end of the world” during them.

Don’t believe yourself if you do not have a better-than-average return rate, or think you’ll be able to achieve high double-digit returns in the medium term. Don’t let your ego make you believe you are right when the price of an investment collapses well below the amount you paid. This is especially true of the losses caused by the crash. You don’t have to prove you’re right by immediately putting more money into a losing investment. This is a mistake because there is no need to quickly return an erroneous investment with the same investment target. It is safer to take a breather and think about what went wrong.

Do not look at the price of a security before making a cash flow statement. Your subconscious can steer the end result towards it when its availability is high. Do not look at the price you paid when making a new cash flow statement for your investment. Your investment does not know how much you paid. The price you pay may not matter at this time.

Bubbles/Booms and crashes part 2 Their reinforcement, and the effect of the money supply

 

Bubbles, booms and crashes reinforce themselves

The financial markets are seen to return to a so-called equilibrium quickly after they have temporarily left it. Mainstream (neoclassical) economists talk about external shocks or momentary changes created by the news that change the reality markets confront. They have a strong faith for a quick return to equilibrium that real life events do not seem to change their perception in one direction or another. Even the prior booms that offered insane prices, and the crashes that followed, have not shaken this faith. Financial markets have escaped equilibrium too far too often. The farther they escape the worse they recover without major damage. Booms and busts go too far from equilibrium and stay there too long for economists’ claims of quick returns to be true.

Exaggerations in the financial markets produce self-reinforcing prices that are too high or too low. One way to explain their reasons is George Soros’s theory of market reflexivity. In engineering terms, there is self-reinforcing feedback. The actions of market participants can be divided into two distinct parts: a situation where participants perceive a situation where they find themselves or where participants influence the situation. Reflexivity is a two-way feedback mechanism where reality shapes thinking and thinking shapes reality. The former is a chain of events where thought and reality converge but never meet. They create self-fulfilling connections that reinforce misunderstandings. Rising prices increase demand without increasing supply and falling prices increase supply without increasing demand.

Reflexivity occurs from time to time. It is important to understand it because it describes situations where misunderstandings can affect prices. Impact requires a strong two-way interaction between participants and the market, reinforcing misunderstandings that become the prevailing reality. Developments that move beyond the market equilibrium have limits. Eventually, the power of change will prove unsustainable and return the market to equilibrium with a self-reinforcing development. Reflexivity moves prices in both directions. Prices may go far below equilibrium. It rarely happens without exorbitant prices.

Effect of the money supply

It is logical that bubbles and booms require an increase in the supply of money in the market and crashes require a decrease in the supply. The above is easy to see by looking at historical statistics on money supply. There are significant differences between the bubbles and normal market fluctuations. The amount of money can rise by tens of percent in a few years. At best, they do the same thing every year. By monitoring the money supply, you can get a better picture of the magnitude of the boom and the duration of its aftermath. Following it, the outbreak of the boom can only be timed afterwards because it is only one factor in a bubble.

The majority of the increase in supply comes from the increase in debt. The increase in volume is influenced by e.g. the price and the amounts and values ​​of the securities required. As the price decreases, demand increases, increasing the money supply, and as it increases, it decreases, while the supply of money is the same. A reduction in the required collateral increases the amount of debt like increases in value. An increase in collateral reduces the amount of debt, such as write-downs. The amount of debt increases the most as prices fall, the amount of collateral required decreases and values rise. The biggest bubbles and booms arise from the self-reinforcing spiral of the previous interaction.

The worst collapses occur when the combined effect of the above raises the amount of debt to unsustainable levels, causing an inverse, self-reinforcing phenomenon in which the amount of debt decreases, additional collateral is required and the value of collateral decreases. The situation is rapidly getting worse. More on these mechanisms can be found in the chapter on the long debt cycle. By monitoring the supply of money, it is not possible to accurately assess the likelihood of a bubble. By only following it, it is not possible to assess whether a crash will occur. Without a sufficient increase in money supply, there will be no booms and the supply of money will almost never be reduced so much that there would be collapses without bubbles.

The amount of money can grow unmanageable, both on its own and with foreign aid. In the first case, government finances need to be large enough for money to grow without a significant weakening of the currency. Examples of the former are the real estate bubbles of the current century in China and the United States. One of the hallmarks of the latter is the massive cash flows from abroad that strengthen the domestic currency. The Asian economic boom of the 1990s is a good example.

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