In the early 17th century, Tulip Mania gripped Holland. The price of premium tulips surged 200 percent over 14 months… then it came crashing right back down.
This pattern has repeated itself again and again, across a wide spectrum of financial markets, for the past 400 years.
The secret to getting in – and out – at the right time is to understand the four stages every bubble goes through. As we explained last week, the four stages of market bubbles are:
1. Stealth phase: A small number of early adopters and “smart money” investors recognize a new market premise or investment story.
2. Awareness phase: The market trends higher, the media picks up the story, and more investors join in.
3. Mania: Continually higher prices and media stories seem to justify the price gains, creating a feedback loop that drives prices indefinitely higher. “Easy” profits intoxicate investors, who irrationally project recent large gains into the future.
4. Blow-off: Price gains stall. Pessimistic stories gain traction. This triggers more selling and amplifies the bearish story. The bubble pops. Buyers disappear, and a negative feedback loop develops as falling prices cause more selling. Prices crash, typically falling about 50 percent, but sometimes dropping below pre-bubble levels.
This pattern is playing out right now in markets around the world, and you can learn to make it your friend.
First, invest during the Stealth phase, before everyone else sees the bubble
George Soros, one of the greatest traders in history, said in 2009: “When I see a bubble forming, I rush in to buy, adding fuel to the fire.”
Discovering an investment angle and recognising its bubble potential before it’s headline news is key. Take the Chinese stock market, for example. In August 2014 the Chinese government, faced with a slowing economy, lowered margin account rates. And China’s state-controlled media ran multiple stories promoting the benefits of stock market investing.
The “smart money” recognised that China’s government was on a mission to drive up share prices and jumped in early. On August 29, 2014, the Shanghai Composite Index was at 2217. On June 12, 2015, it topped out at 5166. That’s a 133 percent gain in just 10 months.
A similar story played out with quantitative easing. In early 2009, the U.S. Federal Reserve was concerned about a slow post-recession rebound. That March, the Fed initiated its first round of quantitative easing (QE1), announcing that it would buy US$1 trillion worth of U.S. Treasury bonds by “printing” money to stoke the economy.
The smart money knew the Fed was about to flood the U.S. economy with money. It was “risk on” in a big way, meaning owning stocks was looking very attractive. QE1 ran from March 2009 until April 2010. It coincided with a nearly 70 percent rise in the S&P 500.
If you miss the Stealth phase, the Awareness phase is the second-best time to invest
The key is to get in before irrational exuberance takes over.
While QE1 caused a big jump in stock prices, by September 2011, the U.S. economy was still sluggish and U.S. stocks were suffering. Investors had become bearish. Then the Fed announced a second round of money printing called “QE2.”
The smart money looked to Japan in the 2000s (the only precedent for quantitative easing) as a model for what might happen.
Japan’s QE1 boosted the Nikkei by 50 percent. Japan’s QE2 drove Japanese stocks up another 80 percent. So the odds favoured the U.S. version of QE2 giving U.S. stocks a second leg up. And that’s exactly what happened. The S&P 500 rallied nearly 20 percent over the next six months.
Your next best bet is to wait patiently for an “inverse bubble”
Just as irrational exuberance can carry a market much higher than economic reality justifies, investors can also oversell markets during bouts of irrational pessimism, pushing markets to excessively low points.
The investing public has a short memory. It’s tempting to forget the terrible market plunges of 2008 and 2009. Still, the recent Brexit sell-off might jostle the memories of anyone lulled to sleep by seemingly ever-rising asset prices. (Global stock markets lost over US$2 trillion in value last Friday, the day after Great Britain voted to leave the EU.)
As global markets get jittery, make a list of the best companies or markets you’d like to own. Determine price levels that would make these investments bargains. If panic drives shares to those levels, it’s time to buy.
Avoid markets and securities in the Mania Phase
It’s not easy to leave a great party, but the best investors are the ones that do. If everyone is buying, stay on the sidelines.
Here’s why. On April 10, 2015, the Shanghai Composite broke above 4000. It was up about 80 percent in eight months. Investors (mostly unsophisticated retail traders) were pouring money into the market. Margin lending had increased 250 percent in six months to a record high. Brokers were opening four million new trading accounts a week to meet demand.
Yet the People’s Daily, the mouthpiece of the Communist Party, declared that the bull market was “just beginning.”
Two months later, on June 12, the Shanghai Composite peaked at 5166. It was up about 130 percent in ten months.
The Chinese were the world’s most optimistic investors, according to a Legg Mason and Citibank survey. Mainland speculators had borrowed US$348 billion to bet on further gains. About 60 percent of them planned to increase their exposure to equities over the next year.
Meanwhile, China’s economy was stuck in its weakest expansion since 1990. Price-to-earnings ratios (P/E; a popular way to measure how expensive stocks are) had climbed to their highest level in five years. At China’s Shenzhen Stock Exchange, famous for its many tech firms, half of the stocks with analyst estimates had a forward P/E above 50. In the previous year, almost half of all Shenzhen stocks had at least doubled in price.
As the head of a financial research firm in Hong Kong said, “We have a wonderful bubble on our hands. Of course, there’s short-term money to be made. But I fear it will not end well.”
Turns out he was definitely right about two of those three statements – there was a “wonderful” bubble… and it did not end well. By July 8, slightly less than a month after hitting its peak, the Shanghai Composite had fallen 32 percent. And by January 28, 2016 it was down 48 percent.
You would have had to sell at exactly the right time to pocket any short-term gains.
When your friends and neighbours are day trading or flipping houses and gloating over their profits, or when your barista is speculating on condos, or your Uber driver is giving you stock tips, it’s probably the Mania phase of a bubble. It’s time to lock in your gains and wait for the inevitable pop.