Bubbles develop and declines manifest in a certain manner. Knowing this pattern, you can book profits and curtail losses
Jojo Puthuparampil
History's first bubble is unrecorded. Perhaps it might have been triggered by Caveman A who traded a lump of brontosaurus flesh to Caveman B in exchange for hunting rights. In modern stock market terminology, a bubble refers to the run-up in share pieces until they reach so high a level that there is no one left who is foolish enough to buy. No one can predict when the bubble is going to burst or when the market is hitting its bottom. However, knowing the way bubbles develop and declines manifest you can book your profits and curtail losses. Allan Campbell’s book charts the pattern booms and panics follow.
Most bubbles tend to develop in a similar manner. Stocks start to rise in value for sound fundamental reasons. However, at some point people no longer buy stocks for their growth potential. They buy simply because stocks are going up. At that point, rational investing turns into 'irrational exuberance', and the bubble begins to inflate. Though we are foolish to buy stocks at this level despite knowing that they are overpriced, someone will be an even greater fool to buy them from us at an even higher price. To hear the bell at the top, turn your TV. "If pundits are talking about a new era for investors, it's time to sell," Campbell says.
Panic also follows a similar irrational logic. As stocks descent from their peaks, the dominant sentiment is to take advantage of the price dips and buy more stocks. This sentiment is especially prevalent if the bubble has been building for a long time, because the longer it has been since the last bear market, the less investors remember that stocks go down as well as up. As a result, there is often the bear-market rally. But when the rally stalls at prices below the previous high, some investors decide to use it as an opportunity to lock in whatever profits they still have. Thus, they sell, sending prices tumbling again. During this second tumble, panic often sets in as investors realise they have missed two opportunities to sell high. Now the concern is no longer about maximising gains, but about minimising losses. And selling is the only way to minimise losses. Every piece of news is interpreted negatively by investors who look for a reason to sell. As stocks go down, panic to sell begets more panic until everyone who wants to sell has sold.
At this point the market is at its bottom. Fortunately, panic, too, wouldn't last for ever. "When pundits start talking about an 'irrational depression' that will not easily be turned around, it's time to buy," Campbell counsels.
Contrarian signals work better in stock markets. That's why listening to conventional wisdom and doing just the opposite of what it suggests is a sound investment strategy. "You would ignore the voice of sentiment only if you are able to quantify whether the market is irrationally undervalued or exuberantly overvalued," Campbell reasons. And there are ample reasons why the market is not efficient but irrational.
The efficient market theory proclaims that the decisions of the well-informed buyers and sellers lead to fair prices. But if the theory is true, then stocks are always fairly priced and it makes as much sense to by them when they are trading at 50 times their earnings as when they are trading at five times. According to behavioural finance, humans possess ample traits that prevent rational stock market behaviour. The most decisive among these traits are: greed and fear (if humans are rational about money, casinos wouldn't exist), self confidence (this trait makes us believe stock market success is a result of skill, when often it is a result of luck), herd instinct (this mentality forces us to believe that the market, or herd, is right and we are wrong when the truth is the other way around), pattern recognition (we tend to see patterns when only randomness exists), myopia or lack of historical vision (we tend to consider recent events more seriously than earlier ones which actually bear more significance), and vanity (instead of admitting we are wrong, we keep on holding and stocks keep going down).
Studies have found that buying stocks when most strategists are bearish and selling them when most are bullish produced better results than buying when P/E ratios are low and selling when they are high.
The reason for this disconnect is simple: strategists tend to be bullish when economic and political conditions are good for stocks. But when conditions are good everyone is buying. By the time you read their recommendations, stocks already reflect the good news and are fully valued or overvalued. Conversely, the strategists are bearish when conditions are bad. But under those conditions, most folks have already sold; so stocks are cheap.
Conventional wisdom tells you not to act until you have all the information you need ('better safe than sorry'; 'look before you leap'). But with the stock market, you never have enough information. You never know what the economy will do or what political surprises are around the bend. But neither does anyone else, which is why stocks are always cheap during times of uncertainty.
When you begin to invest in stock markets, it is better not to listen to self-made pundits who flaunt terms like 'market timing', 'charting' and 'day trading'. These practices contain pitfalls that you might fail to spot. Market timing refers to the strategy of frequently increasing or decreasing your stock holdings in response to expected short-term stock market movements. This strategy doesn't seem to work because no one can predict market movements in the short term when trends appear random.
Technical analysis tells you the prices at which a stock attracted buyers or sellers in the past and indicates at what price it will attract them in future. But the future price of the stock will be determined by events that cannot be known in advance.
Day traders buy and sell stocks throughout the day to capture gains from small price movements. "Don't indulge in this exercise unless spending daytime in front of a computer screen watching your wealth fluctuate from second to second is your idea of fun", cautions Campbell. Beware!
Conquering Stock Market Hype
Author: Allan Campbell
Publisher: McGraw-Hill
Edition: 2004, paperback
Price: Rs725