We are the dot-com generation. As such, we lived through a historic boom and bust bubble cycle that was significantly injurious to the economy. Every American was affected in some way by this event. A key characteristic of the price run-up was that so few were willing to admit there was a problem, and even fewer still were willing to act on that belief.
Now that we’re on the other side of the burst, we may feel as though we’re experts on bubbles. Although we hear talk about bubbles all the time, the truth is that they tend to be rare events. Nevertheless, we look at current market trends and wonder whether it is a bubble or just a strong bull market. What is the difference?
According to one standardized definition (Wikipedia), a speculative bubble is distinguished by “trade in high volumes at prices that are considerably at variance with intrinsic values and could also be described as a situation which asset prices appear to be based on implausible or inconsistent views about the future.” In other words, it’s a mania.
A common historic example is the Dutch tulip price bubble of the mid-1600s when tulip bulbs sold for more than 10 times the income of a skilled craftsman. The only explanation of such a scenario is psychological. In his book “Extraordinary Popular Delusions and the Madness of Crowds,” Charles Mackay explains how a crowd will behave irrationally from time to time. Another popular theory about manias and bubbles is the so-called “greater fool theory” that describes market participants beliving they can speculate on an asset, and no matter how overpriced it gets, they can resell it to some other speculator. This explanation certainly sounds familiar to those caught up in the housing bubble that peaked around 2006.
Riding the bull
We now need to differentiate bubbles from bull markets, which is a trend of confidence and increasing asset prices over a long period of time. A secular trend can last anywhere from five to 20 years. The two most powerful secular stock market trends in the second half of the 20th century lasted 17 years (1949-1966) and 18 years (1982-2000). While a bull market can end with a bubble, most of the time investors were optimistic about the future but did not view the future implausibly until the end.
The main difference between a bull and a bubble is the speculative component. One example is a company called Norris Communications. This was a bulletin board company that changed its name to e.Digital in 1999 when it traded that January at $0.06 per share. By Dec. 31, 1999, it was trading at $2.91. Three weeks later it was at $24.50. It quickly collapsed and resumed its former low price at $0.10 .
Perhaps the key component is the implausibility factor. In the British railway mania of the 1840s, total railway revenues in Britain in 1845 were £6 million. The expectation was for £60 million by 1852 while the actual revenues came in at £15 million. While tenfold increases are the expectation for new technologies or industries, by the 1840s the rails were no longer considered a new technology or industry. There had been a smaller rail bubble in the 1830s in Britain where revenues did increase tenfold. But to continue at that rate invoked the implausibility factor.
A bull and a bubble also can be differentiated by obvious market sentiment. While a bull market climbs a wall of worry — or caution — the characteristic sentiment of a bubble is a laissez-faire attitude and the belief that “this time is different.”
After the financial crisis bottomed in 2009, media commentators would interview many guests and ask if they thought there would be a double-dip recession. The question was asked continuously while the market kept rising. In a bubble, nobody talks about recessions or is even worried about the possibility of a decline. In fact, the key psychological component is denial that prices ever could decline to past levels. Applying this analysis to today’s rising stock market, it would suggest that this is a true bull market, as caution and worry have certainly accompanied the higher prices.
Although the psychological characteristics are interesting, we can turn to chart examples to examine more concrete factors.
There are different ways to define a normal bull market technically, but the best way is simple observation. While a bubble’s key characteristic is a parabolic move, bull markets can have parabolic moves as well. One reliable method is utilizing Andrews’ pitchfork. Many bull patterns in various time frames will stay close to the confines of the upper channel.
Consider a weekly chart of the S&P 500 index (see “Steady rise,” above). During the bull market from 2002-07, it stayed within the upper channel until the end. It also never strayed far from the 50-week moving average. By contrast, “Fast runner” (below) shows the housing stock Lennar Corp. from 1999 until the stock split in January 2004. Already we can see a move far away from the Andrews’ channel and the 50-week moving average. The stock peaked at $68.86 in July 2005, which is pre-split price of $137.
If straying from a standard Andrews channel can be a clue a bubble has materialized, then we also might grow wary from a pattern that requires multiple Andrews’ channels to complete. By itself, this probably isn’t a strong enough signal, but when combined with the psychological aspect of market participants, it can contribute to a fuller understanding.
The gold market during the last decade comes to mind. Here’s a market that grew more than 650% within a decade. But it probably wasn’t the move itself that defined the bubble; it was likely the behavior that propelled the action.
When gold was trading under $1,000, per ounce, experts expected it to go to $3,000, or higher. According to a Fortune magazine article on Oct. 12, 2009, when gold futures were trading at $1,045, top-ranked manager John Hathaway of Tocqueville Gold Fund offered the prediction that gold could rise to more than $5,000. The traditional reason for the forecast was inflationary fears, but like stock prices that rise in a bubble because of implausible views of the future, gold prices do the same. Dire predictions of social unrest, political uncertainty and the collapse of the dollar caused prices to soar. By the end, many pundits were giving lip service to the “bubble” word. If judged by the technical pattern alone, gold’s run certainly looks like a bubble (see “Get some gold,” below). However, when the psychological picture is assessed, the analysis could go either way.
By the end of the price run, Utah passed a bill allowing gold and silver coins issued by the Federal government as legal currency. Utah was the first of 13 states to propose such laws. What the law did was to treat gold and silver coins issued by the U.S. Mint as legal tender for a set value as opposed to market price of the physical metal. For instance, if you had a one-ounce coin worth a one dollar face value, and gold was trading at $1,400 per oz., the value of the coin would be the currency value and not the market value. If someone wanted to buy a candy bar with a coin really worth several hundred dollars, they could do it.
This kind of behavior supports the notion that gold indeed was a bubble. However, the key consideration is that market participants deny a bubble even exists. By the time the precious metals started turning down, there were numerous reports that a bubble had burst. Indeed, while prices were rising, there were also numerous sources suggesting precious metals were forming a bubble. When a real bubble materializes, few, if any, “experts” admit the possibility that mania has set in.
Next in line?
Today, pundits speculate on what the next bubble might be. There is talk that the four-year rally in the stock market is a bubble, as well as debate on whether or not the bond market should be considered a bubble. Because credit has been so cheap for years, is the value of debt unsustainable?
The longer-term continuation chart for the 30-year Treasury bond grew from roughly 55 to 152 in 32 years. By that standard, it’s hardly a bubble. But with the cheap money and engineering by the Federal Reserve, we can hardly call this price rise a bubble built on mania. The Fed has attempted to keep rates low and prices high to stimulate the economy. It’s not implausible behavior considering how much damage was done to the economy in the financial crisis.
Many bull markets, such as the bond market bull from 1949-66, supported three Andrews’ channels with many validations by the time it peaked in 1966 (see “Bond power,” below). However the market never went parabolic, nor was the behavior in the 1950s predicting implausible behavior about the future. However, by the end of every bull market, there is a built-in confidence and optimism about the future, as there is at the end of every business cycle.
Hence in determining a mania, speed of the move and the size of the move go hand in hand. The Nasdaq went from 1343 to 5132 in 18 months. That’s a 282% leap. The bond market, on the other hand, grew 176% in 30 years. And we have the psychological aspect. The implausible factor must be present. Denial must be widespread. If these factors aren’t in place, the bubble is mostly likely a simple bull market. Trade accordingly.
Jeff Greenblatt is the author of “Breakthrough Strategies for Predicting Any Market,” editor of the “Fibonacci Forecaster,” director of Lucas Wave International LLC and has been a private trader for the past eight years.