Tuesday, July 15, 2014

When Bubbles Become Manias: The Psychology of Runaway Markets

From housing in 2007 to dot.com stocks in 2000 and all the way back to those infamous tulip bulbs, we've heard about and experienced market bubbles.  While Eddy Elfenbein might indeed be right when he defines a bubble as a bull market in which we don't have a position, there have certainly been times in which financial assets have become so subject to speculative fervor that they have lost their anchoring to fundamental value.  Consider Japan's Lost Decade following its real estate bubble; it's understandable that investors wish to both avoid bubbles and potentially profit from them.

Can we actually identify bubbles while we are in them, however, and--more to the point--can we anticipate when they might burst?  Abnormal Returns suggests that trying to crystal ball the end of bubbles is not a fruitful use of an investor's time, as peaks are only truly known in hindsight following the initial--and often harrowing--decline.  We've all known market pundits who have predicted 12 of the last 2 market crashes, leaving phenomenal amounts of money on the table for their uncritical followers.

A different perspective, however, is offered by Forbes columnist Jesse Colombo, who provided a heads up on the 2007 housing decline and recently posted 23 eye-opening charts suggesting that stocks are headed for a crash.  Indeed, with central banks seemingly outdoing one another in the race for lower for longer, Jesse finds evidence of bubbles across multiple global markets.  It is difficult to think of another period in which we have not only had bubbles, but a bubble of bubbles.  That has to be a sobering scenario for longer-term investors.

From a psychological perspective, I find it useful to distinguish between bubbles and manias.  A bubble is a financial phenomenon, in which valuations depart greatly from underlying fundamentals.  A mania is a social-psychological situation in which assets are purchased recklessly, with the assumption that they can only go higher.  The famous bubbles of financial history have also had elements of mania.  Indeed, it is the herd behavior of crowds that has created the severe declines that have accompanied the popping of bubbles.  It's possible, however, that bubbles can exist for a period of time before the manic buying and selling leads to a pop.

The useful Stock Charts site shows that the ratio of bullish to bearish investment advisers tracked by Investors Intelligence is higher now than it was at the time of the 2007 and 2000 peaks, suggesting that we are seeing a degree of unbridled enthusiasm.  Per the Abnormal Returns caution, however, it is clear that such enthusiasm can last a while before it ends in tears.  The highest level of bullish-to-bearish sentiment in the last 30 years occurred prior to the 1987 crash--but early in 1986, well before the eventual market peak.

The distinction between bubbles and manias leads to an interesting thesis:  because manias are, by definition, frenzied phenomena, we should expect market volumes and volatility to bottom prior to any manic price peaks.  That, indeed, happened in the 1920s:  average monthly trading volumes in 1925 and 1926 were in the neighborhood of 30 to 40 million.  Monthly volumes in 1927 routinely broke 50 million and in 1928, they exceeded 80 million for 7 months out of the 12.  Seven of the first nine months of 1929--just before the crash--exceeded 80 million, with several over 100 million.  

Volatility bottomed in 1986, well before the 1987 peak preceding the October crash, and we saw a bottom in VIX in 1995, well before the drops of 1998 and 2000.  VIX also bottomed in 2006, considerably in advance of the market demise of 2008.  

In each of these cases, animal spirits began percolating during the period in which bubbles became manias, ahead of market crashes.  Quiet markets are not manic ones, but bubble markets tend to eventually draw animal spirits, as Kindleberger documented.  With volumes currently tame and VIX not so far from those 2006 lows, it is difficult to read the current stock market condition as mania.  Should interest rates rise in the face of rising inflation, however, and the flood of money parked in bonds finally find its great rotation into stocks, we could see those animal spirits return to equity markets amidst the current optimism and lack of financial stress.  

That, history teaches us, generally doesn't end well.

Further Reading:  Bubbles, Booms, and Busts: Why Rational Investors Become Irrational