Article / 29 January 2018 at 12:23 GMT

Brave new world or tulip mania? Ask the charts...

Technical Analyst / Saxo Bank
Denmark
Tulips and crypto
 It couldn't happen again. Could it? Images: Shutterstock

By Kim Cramer Larsson

  • "This time it’s different – it’s a new type of economy 
  • New technology has changed the environment 
  • This is a whole new way of doing business 
  • People don’t understand our business model 
  • Economic theory must to be rewritten 
  • Stocks are in melt-up, not melt down, mode 
  • Bullishness abounds with stratospheric forecasts 
  • They say Bitcoin can go to $50,000 or $100,000   
  • This will revolutionise currencies, trading and the entire financial world"

Listed above are just some of the things that we hear every time that a bubble is building up. And there is, indeed, much debate these days about potential bubbles in stocks, the housing market, and interest rates. But there are probably just as many (if not more) investors, economists, and pundits claiming we are nowhere near a bubble. So who's right?

Clear blue skies ahead

Those who claim we're not in a bubble point out that price-to-earnings levels are not at historic highs, the economy is booming/expanding, and/or that new technology will prove this market to be cheap and the economy will grow even more. 

All this might be true, but contrary to what many economists will tell you, this is not what drives financial markets. Psychology does. Fear, greed, hope, expectations, and social moods drive the market.

However, to determine if we are in a bubble market we first need to understand what a bubble is and try to understand its anatomy... and the aforementioned psychological elements play a huge part.

History repeats itself

Price movements have a tendency to repeat themselves, drawing identical and repetitive patterns in financial markets over time. A bubble pattern is one of the most intriguing patterns around. It is usually characterised by a mere handful of components, which taken together, make bubble-identification easier.

First, there's a baseline where there is little or no interest in the asset. This is usually where the smart money – hedge funds and the like – buy cheap, beaten-down stocks. Then institutional investors such as market pension funds enter the market and prices starts to move.

According to Professor Jean-Paul Rodrigue, there are four main phases in a bubble:
Chart
Source: Jean-Paul Rodrigue/Wikipedia

It is usually during this phase we see the first correction and it is usually a large correction (called a bear trap) where there is great fear in the market that the uptrend since the no-interest phase is ending.

From a technical point of view, we call this a pre-peak. There is no strict rule as to where exactly it occurs, but usually the first one – sometimes there are two large corrections or pre-peaks – occurs during the “institutional phase". 

During these pre-peaks or bear traps many private investors (the few investors that actually jumped in at an early phase) get stopped out only to jump in again at higher levels, making them chase the market higher.

However, confidence is quickly re-established and prices move at an even faster pace, sometimes leading up to the second large correction or pre-peak shortly before the blowout top. As can be seen by studying the various bubbles over time, a bubble ends with a blowout top. A blowout top occurs when the market/price is rising almost vertically. It is primarily private investors chasing the market higher while “smart money” and some institutional investors start to pull out.

During the last rally to the top there is a growing fear amongst (private) investors of losing out, not being a part of the rally, and hearing from friends, family, and the media that virtually everybody else is making (easy) money in the stock market (or Bitcoin, or housing...). 

They buy without thinking about risk because they think or feel there is none. Prices have gone up and up and up for a long time, convincing everybody that they can only continue rising.

When a bubble implodes, few people notice it to begin with. Some say a crash is silent. It's not, but many are still taken by surprise. The reason most people don't notice until prices are imploding is they will not admit or listen to those saying a price is about to peak, or already has peaked. Their rationale is that the price “can only go up”, and they put their faith in concepts like "new economy/new way of doing business/new scenario/new calculation method/revolutionary product/et cetera, as well as in the analysts employed by sell-side firms who've been saying that good times are here to stay.

When a bubble implodes the price always comes down to at least the highest pre-peak but very often also down to the lowest – if there have been two – or even all the way down to the price “base” as can be seen in later examples. And this happens relatively fast, usually faster than when prices went up. The reason for this is that most traders and investors are now under water, seeing losses on their holdings. They panic sell and suddenly there aren't many buyers around.

The psychology

To understand the psychology behind a bubble and the implosion thereof, I'll add a few more emotionally-driven phrases to some examples of bubbles. Doing this gives us a better idea of where we are in the life cycle of a bubble. However, to understand this psychology we first need to have a look at the human psychology of trading or investing. 

What are our emotions during trading and investing?

chart
 
Source: Westcore Funds / Denver Investment Advisors LLC, 1998

First you buy an asset, let’s say a share in a company. You are optimistic about your new investment. Why not? Otherwise you wouldn’t have bought it in the first place. The price goes up and you get excited, maybe even thrilled, the more the price goes up. You think it is your “own success” the price is going up even though the market most likely also goes up (even more).
You brag about your investment and talk to other like-minded people.

Then a little setback occurs and you get a little nervous but you are still in the money. The setback, a drop in the share price, deepens. You convince yourself it is still a great investment because the company makes terrific phones, cars, tools etc. The "market is wrong and the sellers will regret it".

Now the price is below the price at which you bought in the first place and you tell yourself you will sell when it returns to the buying price. Maybe you even buy more to bring down your average price, (this looks better in percentage terms in your account). Also, you have suddenly changed your investment horizon from short- (you were a trader) to long-term.

The selloff continues at an even faster pace and you start to panic. Maybe you have borrowed money to invest and you start to realise that maybe you shouldn’t give up your day job after all.
The last straw is when you sell everything. Your investment is maybe out of pocket by more than 50% and all the market news is negative, people are talking about crisis, and you need the cash – you sell.

Unfortunately, it will later show, that was just around the bottom price on the chart.

Bubbles in real life

The first known bubble was the famous Tulip bubble in 1634-1637. Back then, the now-ubiquitous tulip was a relatively new arrival to northern Europe and was much admired and sought after even if there was very little knowledge of proper cultivation methods and disease avoidance. 

People in Holland speculated on tulip bulb prices, taking the price of a single bulb to a value higher than that of a house. The bubble imploded quickly, leaving a lot of people bankrupt.

tulips
 























Source: Elliott Wave International

On the financial markets we have seen several bubbles over the past 150 years. The railroad bubble in 1880s followed by the probably most famous stock market bubble in history: the 1920s. 

A major crash in 1929 lead to the Great Depression in the 1930s; this is a textbook example of a bubble and the bursting thereof.

chart
Source: CQG

But surely we have learned from that? Unfortunately not.

Since then we have had the gold bubble, the bubble in the Japanese housing market,  and the Nikkei in the 1980s. We have seen the oil bubble (2001-2008), the bubble in the South African rand (1990-2000), the dot-com bubble, and Iceland (2000-2007) when it invented a new economy, along with several other bubbles in gold and silver. 

The list is long and it keeps growing because we never learn.

But Bitcoin – this is different, right? Well I will let the chart speak for itself:

Bitcoin
 
Bitcoin ETF: Source: SaxoBank

Haven’t we seen this before? Why do we keep making the same mistakes? As one of the most famous speculators/investors, Jesse Livermore (1877-1940), once said: “Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes." 

He was short during the 1929 crash.

The anatomy of a bubble

If we view these emotions in the context of a classic bubble, the dot-com bubble of the 1990s, along with monetary and credit market conditions such as credit availability and margin spreads, we get a good picture of what’s going on during a bubble's buildup and subsequent implosion.

Nasdaq
Source: The author.

As you can see, the current price action has all the characteristics of a bubble; it's very similar to all the other bubbles illustrated here.

But now we have learned? Surely today's stock market is sound and economic growth is supporting stocks – particularly the rising US market. Well, I will let economists talk and fight about the state of the economy, just let me ask this question: How many predicted the 1929 crash, the dot-com crash or the “great financial crisis”?

"There is no cause to worry. The high tide of prosperity will continue" — Andrew W. Mellon, US Secretary of the Treasury, in Sept. 1929, one month before the crash that led to the Great Depression. 

Shouldn’t he have known?

Building a new bubble are we? Or is it really different this time?

So where are we now? Are we in a bubble and if so, is it about to burst? It is very difficult to call the exact top of a bubble. However, we can use a range of technical tools to try to read the market.

Some of the questions we should ask ourselves are:

  • Is volume supporting the upturn? Are all (or the majority of) stocks driving the market? After all, the fewer stocks that are driving the market higher, the more fragile the uptrend. Is sentiment or the social mood as it normally is near the peak ?
  • It is the longest period of monthly gains ever seen in history. Not even in the roaring '20s did the market record this amount of consecutive months with a positive gain.
  • We have the highest amount of days without a 3% drop in prices ever! And don’t we hear some of the same phrases as we have before?


To get a better idea, I have added the aforementioned emotions and monetary conditions to the Nasdaq Composite chart from 2009 until the present. This is not to claim that the market is about to top out and we will soon see a crash! This is not what this article is about. It is merely just an indication of where we might be at current levels. 

Compared to historic bubbles, there could still be a way to go before we see a blowout top, but the pattern is quite similar to previous bubbles.

So what is actually going on here in 2017- 2018? Is it different this time around? We hear a lot about social media, robots, and other technology that will "change everything" – the way we work, if we work,  the economy, and our social life. That is different... isn’t it?

It is different. But then, it was also "different" when we moved away from farming being the largest economic sector and into industrial society. It was "different" when railroads revolutionised transport, when Henry Ford invented the conveyor belt and replaced horse-drawn buggies with (relatively) cheap cars and trucks.

But ask yourself: how many people that you know are suddenly talking about investing in stocks and/or Bitcoin? People who have never invested in anything before!

When I mention to people (who care to listen) that I am hearing the same phrases as I did in the 1990s and that I can feel the same energy and attitude towards risk and “prices can only go up” as when I was working in London as a stockbroker, people smile at me and sometimes roll their eyes.

For example, take this recent story on MarketWatch: “the unsinkable US stock market just tied a historic record for not falling.”

chart
Source: Kim Cramer Larsson

Maybe I am just an old geezer and this time it really is different.

But maybe, just maybe... it’s not any different this time. If this is the case, I have only one piece of advice: keep your stops tight.

— Edited by Clare MacCarthy

Kim Cramer Larsson is a technical analyst at Saxo Bank 

Download document

Bubble examples

29 January
Market Predator Market Predator
@Kim: this is very interesting reading, thx!
btw: hot news, crypto fraud worth US$ 530 millions! Video here: http://www.reuters.tv/v/we8/2018/01/29/cryptocurrency-scrutiny-in-japan-after-530-million-heist
29 January
djustoe djustoe
Can anyone tell where I can find the most up to date numbers on institutional equity flows? (excluding subscription based content) thanks
30 January
Alan M Alan M
Lots of talk around amazon this morning, but speaking of bubbles, this looks insane!

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