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The Anatomy of a Bubble-II

January 14, 2009
The analysis of past stock market bubbles can create an ‘edge’ for traders which can be seldom replicated by the crowd.

A Bubble

Stock markets in India have changed from a routine up,down,up move to something bigger and much more exciting. The rhythm of 1993-94, gave way to spectacular, straight up run away in prices. In other words- a mania.

Manias are rare[at least it should be] episodes, where ever-higher prices create a carnival and no holds barred atmosphere in the financial realm that eventually moves outward to society itself. An extreme, self-reinforcing optimism that forms the hallmark of financial manias.

Studies of past manias can form an important lesson for a trader and can give him an edge seldom recreated by other people. In other words, an ‘edge’. Its this edge which can make or mar a traders career.Its possible to make significant money during a mania, but its when the mania ends, that there is even more to be made.

Its a mania if:

  • there is no upside resistance and rising prices seem perpetual, bulls becoming complacent
  • everyone, even your neighbors and their sisters, seem like an expert
  • there is a flight, an exodus in no less terms, from safer investments to riskier investments
  • financial bubbles pop in one area while continuing to bubble in others

The first and foremost sign of a mania is virtual absence of any worthwhile resistance. Albeit, Indian markets did face their part of resistances in the initial part of run up to 21k, but 2006-2007, indeed pushed our markets into a mania. Imagine 2000 point climb in Sensex within a week. It was shocking and frightening.

Historically the crash looks like a fall to ‘Never Never Land’, fuelled by what Galbraith said, “mass disillusion and crash”.

“It never comes gently”, Galbraith said and “is always accompanied by a desperate and largely unsuccessful effort to get out”. What gives rise is instead the famous sky scrapper patterns.

kendall_1

Keys to UNLOCKING a mania

One key to deciphering whether a run-up is a mere bull market or a true mania is to notice how financial experts are treated. Usually in a mania, investors and traders give experts short shrift, preferring instead to get their investment advice from amateurs.

Indeed, when a mania is nearing completion, people actually treat professionals who are knowledgeable about history and value as impediments to their success.Even after the NASDAQ began its historic collapse, professional wrestlers offered up stock picks on CNBC. The same thing with SENSEX/NIFTY crash, when the crash began, there were a lot of buy signals generated. Not by the system but by the ‘experts’ who came buzzing towards the market in the bull run up.

Another indication might be a qualitative feel of the blogosphere. To see, how many start blogs/sites for selling tips,newsletters etc.

Another important indication might be the level of investment sophistication. Wall Street Journal reported that common investment strategies in China include ” buying stocks with 8 in its ticker code”, “eating beef to sustain bull run” and “wearing red to signal hot tickers”.

In India itself, buying on news became a high paying investment strategy. Astrology and Numerology were close seconds.

The Flight from Quality

The end phase of the mania incorporates huge exodus from quality investments to riskier investments. During the Dot Com Boom, investors made it sure, entrepreneurs issued IPOs first and business plan second. Even in, our Indian markets, Reliance Power having no assets, just promised plans became the biggest IPO, (and also the last) in the last bull run. Our mania to fuel and fund those companies which burned cash, was also a huge red flag in favour of deciding its a mania.

Bubbles Pop!

Perhaps the last marker in such a maniac situation is the blind optimism which keeps a bubble in place at one geographical or asset class, though bubbles pop in other geographical and asset categories. Neiderhoffer believes that, there is somewhat of a synchronicity in market movements, first equity class turns, then asset class turns, then realty turns, the economy turns. A reverse domino effect where each markets in interlinked with another. So in light of this, even when bubble at one place bursts, a continuous frenzy in the other, is often the last nail in the coffin. An example of sorts is the 2000 point climb in Sensex, in three trading sessions in the wake of the first cases of sub prime crisis in US.

Knowing the traits of historical and current financial manias can help traders to position their accounts for a fall that will be even more relentless than the virtually across-the-board advance of the bubble they were in. And even though the flipside of financial folly is not as much fun as the run up, it can be just as exhilarating to those who are on the right side.

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