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

Deeper anatomy of cycles

 

Deeper anatomy of cycles

The introduction briefly discussed the anatomy of cycles and found that the main directions of economic cycles were ascending. In the long run, growth is steady, but in the shorter ones it fluctuates around a long term growth rate. For example, the average growth rates of developed economies are about two percent over decades. Annual growth can be well above that or go negative. Almost all cycles exaggerate the lengths of both their ups and downs and the pace of change.

Defining stages is not rocket science. All stages are not inevitable but also necessary. No precise scientific definition has been made. It is up to you how you define the different stages of the cycle, but I personally use the following stages:

1. Rise after reaching the bottom
2. The peak
3. Decline after peaking
4. The bottom

The rise starts from the bottom, pointing upwards past trend growth towards the top. That is the slowest stage. The duration is often multiple compared to the decline. Long cycles can last decades and medium ones from a few years to a decade. They do not mean continuous upward movement but may include both lateral movement and shorter descents. The annual rate of increase on the basis of the peak exceeds the average trend growth. This is not to say that the rise in individual years could not be slower than the trend between bottom and peak. The rise is usually the fastest after the bottoms and before the peak. Long cycles almost always rise higher than previous peaks.

The lengths and durations of the rises depend on the bases and declines of previous cycles. The lengths of the cycles and their phases cannot be known in advance. Mass psychology is unpredictable and the size of madness or reasonableness cannot be predicted in advance. They cannot be determined by mathematical formulas, even if attempted. Share prices, real estate and commodity prices do not follow pre-defined limits. They can multiply in a short time or drop more than 80%. The best examples of the above are the sevenfold increase in the Nikkei Index in 1980s Japan and the more than 80% decline in the Dow Jones Index from 1929 to 1932. Investors with bad timing will never get their money back. This is true at least in Japan where previous peaks have not been reached.

During the ups and downs, positive emotions and negative emotions like jealousy become stronger. The latter is most evident in the minds of outsiders. Emotional states reinforce themselves until they are close to or at their extremes. In addition to jealousy, positive psychological factors are at their strongest point towards the end of the upswing. The factors are e.g. social proof, the illusion of availability, the illusion of scarcity, and new, old displacing authorities. The number of people staring from the side and suffering from envy is at its highest. Many of them think, "How can a neighbor's fool, John Doe, be able to make that much money, even if he doesn't understand anything about investing?"

Social proof is at its highest, with the largest possible group believing that they will get rich with little effort because others around them believe the same. Everyone is starting to get tips from their environment. They can come from neighbors who have never invested but have started making money. They can also come from co-workers or close relatives. The availability of positive signals from elsewhere is increasing.

The end of the ascension also brings forth new, old substituting authorities. In this case, you will find several new investors who have made a lot of money. The general public is starting to listen to them, even though their success as investors has only lasted a few years. Old authorities that have succeeded in the market for decades are ignored as having seen their best days, as senile, as incomprehensible about the new economy, and as longing for the past. Without their warnings, the enthusiasm created by the positive factors would be smaller. Most of the time, they’re finally right, even though some of them are trying to make money in the final moments of the rise. In particular, central bankers and other regulators need to be silent if they are not prepared to act at the same time. Without action, they will allow investors to do stupid things because they show acceptance of high prices.

The further the ascent progresses, the more creations of financial engineers will appear. There is always a new popular investment vehicle that is a new form of “alphabet” (SPAC, MBS, CDO, etc.). What they have in common is complexity. Some of them can only be described with reports of thousands of pages. They are usually combined with hundreds of junk papers that no sensible investor would buy individually. They are sold as great investments. Even credit rating agencies cannot or will not have time to go through the content properly. In other words, they are classified as safer than what reality ultimately tells us. The pile of crap is always crap, even if it is coated with gold or has a great name.

They can be considered obvious scams and they are, but the big boys mostly survive with remarks or small fines compared to the damage done to customers. The caravan passes and the million-dollar bonuses move. They recommend investment vehicles even when they themselves are selling as fast as they can without crashing their price.

Market peaks are not always a single spike up, followed by fast decline. A larger decline may begin much later. Bankruptcies or forced sales of new market gurus must be seen before the big fall. The peaks include excessive lending and borrowing, the apostles of the new economy, the growth of economic scams, etc. The intensity of the peaks varies. In developed economies, the peaks of cycles are often the result of euphoria or bubbles, depending on what designation you want to give them. In them, nonsense goes further. I'll come back to the bubbles later.

The falls are faster than the rises. A decade’s rise usually causes a few years of decline, but it can be faster. The duration depends most on the previous peak and the resulting rise and the reasons associated with it. The more exaggerated the peak, the longer the decline, at least in terms of length. In most cases, the decline is below the average trend line. The decline may not be prolonged over time. The signs of the start of the invoice are e.g. the departure of the apostles of the new economy to the rear left, the increase in the mention of financial scams in the press, the revelation to the general public of the weaknesses of the new creations of financial engineers, etc.

During the descents, negative emotions and joy of harm become stronger. The latter is visible to non-market participants. The “what I said” reaction is most common near the bottom. The bottoms also contain an increasing amount of bankruptcies. Panic describes the mental state of several actors, although the situation does not get worse. The situation is escalating rapidly, but the worst is passing by.

Introduction

Cycles are essentially chains of events produced by continuous, similar causes, patterns, and consequences. When one runs out, the other often begins. Cycles occur everywhere, such as in nature and human behavior. They are self-evident for many, but fewer really understand them. The cycles that occur in nature are familiar to everyone, but fewer investors understand the cycles of the economy, financial markets and companies that are more important to them. The cyclicality of the latter occurs, for example, in their performance, life cycle and regulation.

Economic cycles are more than just numbers. Understanding them requires an understanding of several factors, such as the interaction between different causal relationships, types of people and generations, and an understanding of the social epidemics. Partial misunderstanding of economic cycles is essential to their existence. So many economists as well as ordinary people miss their effect on them.

Short introduction of the anatomy of the cycles

The main features of the economic cycles are not significantly different. No cycle is similar in duration, but they resemble each other. In other words, current cycles do not repeat the past, but they are not fundamentally different from it. Their duration, timings, causes, and details vary, but they are similar. One major similarity in the vast majority of economic cycles is that their stages take place in the same order and those are almost the same in each. Stages are not always measurable or easily detected.

I divide the measured economic cycles roughly into ascent, peak, descent and bottom. Some people divide the different stages into smaller parts. Sometimes I talk about recession instead of the bottom and top instead of the peak. Peaks and bottoms are the most significant. Understanding of their possible existence gives investors higher odds of better returns and to avoid losses. They are better suited to do the latter. Perceiving the closeness of tops and bottoms is important. Of the other stages, the investor needs to care less excluding the separation of directions. Peaks and bottoms cannot be predicted in advance. Their probabilities at some time intervals, on the other hand, can be perceived.

Long economic cycles are mostly ascending. In national economies, financial markets and companies, the main trend is upwards. They have an average growth rate that is almost constant over the long term. At shorter intervals, the pace fluctuates significantly both up and down. Some cycles fluctuate on both sides of the average growth rate. For example, the average growth of the S & P500 index has been around 7% between 1960 and 2020, but the average annual growth rate has been 4-10% only six times. The largest single annual increase has been 34.1% and the annual decrease has been 38.5%. Large deviations from the average are not uncommon.

Cycles are continuous, consist of several shorter cycles, and intertwine. The former affects the following and so on. Ends of the cycles should be seen as new beginnings, although they can do significant damage. For example, the position of the United States as a leading economic country began with the end of England. The closer the cycles are to each other, the more they have an effect on each other. Cycles include shorter internal cycles. For example, a long debt cycle consists of several short debt cycles. The cycles also intertwine. For example, long debt cycles are intertwined with long socioeconomic cycles.

We are living in interesting times for long-term cycles, such as the world leader cycle, the long debt cycle and the sociological cycle. The latter apply at least to the West and the former to all. They integrate into one large unity, which does not directly affect everyone. In a few years, they happen as much as in other moments of the cycles combined. For adults, these are unique events. The above cycles affect every investor, but they have the biggest impact on index investors.

Misunderstandings

Misunderstanding of economic cycles destroys the economies of investors, businesses, and economies. In addition, minor losses, such as significant capital losses, follow. The extremes and peaks of long cycles arise from excesses. They are the result of excessive enthusiasm and panic. They are the sum of many factors. Few realize that they are exaggerating the extremes of the cycles.

There are three types of people: those who cannot count and those who can. There are three types of people when it comes to economic cycles: Those who understand that they do not exactly understand the cycles and do not try to benefit from the extremes, those who believe that they do not accurately understand them, but believe that they can benefit from the extremes and those who do not understand the cycles. Most of the latter two groups are likely to end up suffering more from the cycles than benefiting from them. Because the extremes of cycles are often farther than anyone believes so many will benefit from them for a long time, but will end up suffering even more.

The worst thing about them is that the worst cycles are not understood by mainstream economists. These individuals, who believe in neoclassical economics and their models, think that price changes are inherently stable, random, and small, although empirical evidence does not support the assumptions. According to the economic models they use, there will be no severe recessions or financial crises. According to their models, the negative effects are so short-lived and small that they do not need to be taken into account. Central bankers have the most power. Their misunderstandings are best reflected in the fact that they believe the market economy is the best price setter, but they still control the price of money. It’s the same thing as believing other cars will be destroyed in a severe collision, but believing the same doesn’t apply to your own car.

They believe they can manage and predict economic cycles because their models mostly work well. In reality, models do more harm when they are wrong than they do good when they are right. The reason can be found in incorrect assumptions such as too small price fluctuations. In particular, financial market volatility is mostly small, but the effects are non-linear. In other words, small fluctuations are the most common, but the total changes caused by rare large price movements are the most significant. The same goes for economic cycles.

There are many common myths about cycles. One form of myth is their fixed duration. There is always evidence for any length of the cycle when you want to find it. People often look for evidence elsewhere if it is not present in the primary target. If the stock market does not crash in a steady cycle, then evidence is sought elsewhere, such as in bonds, etc. By believing in myths, even money that should not be lost can go. Duration can often be similar, but they are not always the same.

The duration of cycles that are significant for investors range from short to centuries. Everyone needs to understand the cycles that are important to them and their lengths. For example, an investor in a country-specific index fund must realize that the lengths of important cycles are years, decades, or centuries. Lengths are not only related to investment targets but to a person’s psychological characteristics. Not everyone can manage long-term investments. They can do better when they focus on short cycles. The book mostly focuses on cycles that last for years because I myself have focused on them.

About the content

The main parts of the content are the deeper anatomy of the cycles, the cycles related to the national economies, the cycles related to the financial markets and the life cycles of companies. It also addresses the intersection of three important economic cycles and the real estate and commodity cycles. The deeper anatomy of the cycles deals with their psychological profile as well as the factors that shape extremes. National economic cycles include e.g. the cycle of economic development and the cycle of a leading economic country. Financial market cycles include e.g. long debt cycles and stock market cycles. Life cycles related to companies include e.g. technology adoption cycle and industry life cycle. Real estate and commodity cycles have been treated only superficially due to the author’s lack of understanding.

In addition, it explains how an investor can identify the conditions of booms and bubbles prior to collapses. Efforts have been made to present cycles by multiplying their course by cause-and-effect relationships, mostly without numbers. More important than numbers is to understand the course of the cycles and the factors that interact to drive the cycles consistently. The book has focused at least on medium cycles. In perceiving them, numbers can be more misleading if cause-and-effect relationships or the course of cycles are not properly understood.

In today’s world, everything affects everything, so the cycles in the book are more or less related. In particular, the cycles of the national economies and the financial markets are often highly interdependent. Business cycles are also dependent on national economies and financial markets. The latter do not decide the fate of individual companies. It can be said that some companies are not affected.

The book deals with the anatomy of cycles and the following cycles and life cycles:

• Long psychological / socioeconomic cycle

• Economic development cycle

• Leading economy cycle

• Reserve currency cycle

• Long and short debt cycles

• Stock market cycles

• Technology life cycle

• Industry life cycle

• Business life cycle

• Real estate cycle

The main purpose of the book is to improve the reader’s chances of increasing investment returns by better understanding the cycles related to economics and investments. Improving revenue is most likely to happen by reducing the number of stupid decisions made by readers than by providing magical insights. Warren Buffett and Charlie Munger have often mentioned that they are not particularly wise, but avoid stupidity better than others. This makes sense for the sake of mathematical facts alone. As most people know, a 50% decrease requires a 100% increase, and so on.

The focus is on the extremes and extremes of the cycles, i.e. mainly bubbles, peaks, bottoms, possible crashes, beginnings, and endings. Other parts are less important. One reason for emphasizing the extremes is that, in my view, many long-term cycles are at or near the end or just past them. The ends and the beginnings refer to those cycles without peaks and bottoms. This is the case, for example, with a long psychological / socioeconomic cycle. Extremes are also the moments when the biggest differences are made in investment returns.

In my experience, the book’s publishing platform doesn’t produce clear graphs, so I’ve left them out. I have reduced the time and effort of the reader by keeping the book short. The book is supposed to follow the principle: “the price is what you pay and the value is what you get” In my experience, the number of pages does not match the benefits of non-fiction books.

The book is not for novice investors. It does not explain everything in detail. The reader needs to know what the basic concepts like P / E ratio, Return on Equity and Earnings per share mean. A broader understanding of the economy is desirable but not essential. An open mind is also important because the book calls into question many things that at least economists consider true. Independent thinking is also essential. No book offers absolute truth about the economy because it cannot be found. The world is too complex for today’s computing power. This book does not offer it either, as the author knows his limitations.

The book contains a few investment ideas. If they are found, they are vague in the style of "substances used for intoxication can be a good investment in Awakening." (An explanation of the former can be found later.) The book does not contain exact predictions of what is to come, but it gives a broad explanation of what may happen or what is the most likely option for the future. It does not predict when anything will happen.