The Story of A Bubble – The Final Stages

A question that I was asked quite often recently is why rational people should purchase stocks that are vastly overpriced by all conventional measures of value and probably with more than just an inkling that the market is in a bubble. Surely the majority of people can not become completely irrational and lose all sense of proportion to that degree?

Searching for an answer prompted much though and I may have come upon an answer. Part of it lies in one of the two widely acknowledged driving forces of markets, fear and greed, and the other part seems to live in our genes as one of the keys to the success of human evolution and dominance. This is our ability to adapt mentally to changing circumstances in ways that enable us to obtain the maximum benefit from the changes.

Our ability to adapt

The greed side of it will get attention soon, but we first need to take a look at the matter of adaptation and how our ability to adjust quite rapidly in fact to major changes in our environment is an advantage.

In most cases the environment in which we grow up and later live changes gradually and we are hardly aware of any changes in our mental make-up as we adjust to these changes. Sometimes, though, a change happens quite rapidly and is of sufficient magnitude to affect much or our daily routine and, of greater importance, also bring about significant changes to the way we view and experience the world.

While we then are fully aware of the fact that our world has been turned upside down to some degree and that the change would last quite long or even be permanent, we are far less aware of the process of adjustment that begins almost immediately and turns the change, if it is permanent, in to what we accept as the natural order of things. Some of these changes that affect most of us is marriage and then the arrival of the first baby. Whether man or woman, these changes have a dramatic and sudden effect on the way we live. Everything is new and often quite different to the way we lived prior to the event, yet within almost a matter of weeks, definitely within months, the majority of us have adjusted successfully to a major and fundamental shift in our lives.

Perhaps the biggest change faced by some people is front line combat. From a life in which life itself is seen as highly valued and widely respected the soldier is suddenly transported into a world where respect life is secondary to a host of other factors – discipline, the team, Our Country, "Take that hill" – and the primary objective next to attempts at survival has become to deprive "The Enemy" of his life. Everything we have been accustomed to all our lives have gone – safety, comfort, peace and quiet with little interference in the way we live our personal lives, to be replaced with physical danger, discomfort, disruptions to routine and loss of practically all ability to adjust personal lifestyle the way we want it.

Yet, within weeks the new life seems normal; natural, as if that is the way men are supposed to live.

What has this to do with a bubble market? Quite a lot, as we shall see later.

The process of bubble formation

The transition from a normal everyday bull market is gradual, to the extent that one can hardly pin any date to when the one changed irrevocably into the other. If a transition point had to be selected, I would guess that it is when the Advance-Decline line finally diverges from the main market indices. The reason for this preference follows from the evolution of a bubble, discussed below.

Perhaps the best way to describe the nature of the decisions that eventually create a bubble and then keep on sustaining its growth would be to let you, the reader, make decisions in a simulated market as it changes over time. As you make the decisions, try and keep track of why you select the options that you do and also how comfortable you would have been with them if they had been made in real life -–as you quite possible have done in the past.

Assume that you are the sole fund manager of a billion dollar equity fund. The rules of the fund are that you have to be 90% invested in equities at all times. Secondly, the salary you receive is comfortable, but by no means support a life of glaring luxury. You main income is really derived from the performance of your fund relative to other similar funds.

Move higher in the top 10% of funds on a quarter by quarter basis and your bonus is increased substantially and could become magnificent in the full sense of the word. Drift down to the middle 20% of all the funds and your bonus ceases to make that much difference to your lifestyle. When you move into the lower 25% of the ratings and the bonus disappears, while the same is likely to happen to your job if your slide carries you into the bottom 10% or even 15%.

Observe that this is not too different from reality in most privately managed funds.

Just 100 companies are listed on the stock market, arranged in 10 sectors of 10 stocks each. The sectors run from A to J, and the stocks within each sector from Aa to Aj through to Ja to Jj. At all times you have access to the financial reports of all companies as well as forecasts by analysts of how they are expected to do in the future. You are also wired into the financial media and are kept abreast of popular opinion at all times.

We begin with an economy that has come out of recession and is experiencing good growth over a broad front. In the different developing scenarios below, record the option you select from the alternatives that are supplied.

Scenario A: You have just been placed in charge of this new fund. You have sole control and the $1 billion lies at the broker in your account. You now have to meet the primary objective given to you and must remain almost fully invested at all times. PE's have been rising as investors begin to prepare positions for the period of good economic growth that is anticipated, but the PE's are as yet evenly spread across all the sectors and the stocks within the sectors.

A1: You spread you funds evenly across the sectors to give yourself statistically the best chance of having some funds in the better performing sectors

A2: You use your experience and the input you get from analysts and the media to place somewhat More funds in the 6 or 7 sectors you think will do better, reducing the investments in the sectors that you think would lag

A3: You rather more aggressively punt 3 or 4 sectors, with some funds in another 2 or 3 and a few sectors being totally disregarded in you plan of action.

Scenario B: The economy is in full swing, and all companies are doing well. However, certain sectors, A through to E, are beginning to show really good growth, with expectations for sustained improvement in company earnings based on better productivity and the use of new technology. PE's in these sectors are moving up above 20 to reveal that investors have been bidding more aggressively to have their orders filled.

B1: You keep your funds evenly invested as you are positive the lagging sectors will catch up to the rest soon, giving you overall better growth than funds invested in the currently "hot" sectors.

B2: You move some of your funds so that you are more invested in sectors A through E, but you leave some funds in the other sectors as they represent good value and might still catch up to the rest of the market to give you an edge.

B3: You move all your funds into sectors A through E', knowing full well that is where the action for the next quarter will be

Scenario C: PE's in sectors A through to E are moving up to and have even exceeded 30. Company results in these sectors are showing good growth, but the analysts and the media are beginning to devote most of their time to sectors A and B. They are the ones where PE's have broken above 30, but the historically high ratings is being justified on the excellent prospects for companies in these sectors over the next 2 years. Their markets are growing at leaps and bounds, even by comparison to the really good performance of sectors C, D and E.

The other five sectors are also showing good and consistent growth over a wide front of companies, but company earnings fall a little short of the stellar prospects held out for sectors A and B.

C1: You begin to have your doubts about the wisdom of having any funds invested at all in sectors F through J. Your bonus the last quarter was nothing to write home about and barely enabled you to upgrade you car to the latest model. So now you begin to move funds out of the worst of these 5 sectors to invest more in the two top performing sectors. You have some catch-up to do and hope to free the funds soon so that you too can enjoy the steep run of prices in the top 5 sectors where your investment are actually doing very well indeed.

C2: You have slipped from the top 25% of funds and the size of your bonus reflects this loss of stature. You intend to make up the lost ground and aggressively sell your remaining positions in sectors F through to J and move the funds into the top 5 sectors. You try to open positions in sectors A and B at reasonable prices and is parking the funds in sectors C to E while you wait for dips in the prices of the top performers. Whereas earlier you were more concerned about allocation of funds to sectors, your focus is now switching to individual companies in the top two sectors.

C3: You have been gradually selling out your positions in sectors C, D and E – moving the funds into sectors A and B in order to achieve your ambition of being in the top 5 % of fund managers. The fact that the PE's are somewhat unrealistic and that the hype about these companies seem just a touch over-optimistic is of little concern. The economy has been growing strongly for some time now and things look really good for the next few years.

Scenario D: Prices of most stocks in sectors F to J have been in a decline for some time and even companies in sectors C to E are losing support from investors. The A/D line has turned down, diverging from the main market indices. These sectors are receiving quite little attention from analysts and are practically disregarded by the popular financial media. Many stocks in sectors A and B are becoming household names and one just have to listen in public places to hear that many conversations deal with how these stocks have performed recently.

The PE ratios of some favourites are reaching 50 and a few warning voices are heard that it is unrealistic to pay a price for a stock that would take 50 years at current earnings to be repaid. Given the strong growth prospects in these newly developing markets, the gurus of the investment world assure investors that current prices will look really cheap one year down the line. So what if a PE is 60? With earnings thought to rise by 25% compounded over the next 3 years, the PE at the current price will be below 30 just 3 years, with much steep growth still to come.

D1: You are at risk of losing your job. This is the time to really do something about it and you try to sell your last positions in sectors F-J at best, but bids are few and far between and prices fall steeply. Life is difficult. Any funds released are moved into the top two sectors, A and B, and you continually remind yourself if you had been more aggressive in your investment strategy in the past matters would not have come to this point.

D2: You have at least stabilised your position in the rankings and you fund is showing good growth. But not good enough to matter where it does most – in the size of your bonus. You now sell all your positions in sectors C-E, even accepting a fall in the price simply to get out. You have decided to have price charts of the top performing companies in sectors A and B on the walls of your office and to concentrate your money in these. Allocation of funds is no longer a matter of selecting the right sector, but finding the right company to be in.

D3: For some time now you have used technical charting methods to select the right stocks to own. You have noticed that there are flavours of the month and that while the sector as a whole is moving consistently upwards, at least sectors A and B, not all the stocks in the sector do so at the same time. By switching funds more rapidly from one hot performer of the month to the next you intend to maintain yourself firmly in the top 5% of fund managers and you just love your bonus. If you could just crack the top 1% . . !

Scenario E: The A/D line is showing that the market as a whole is in a sustained bear trend, but anyone who comments on this is shown a chart or statistics on the tremendous performance by the market indices over the past year. Even normal daily newspapers now have their section for comments on the stock market up front, not buried at the back Channels on the TV cover just business 24 hours a day and how much money one is making is the subject of most conversations where people meet. If one has not hocked his house to the limit and is a regular visitor at the bank manager to discuss one's portfolio of investments preparatory to asking for another loan, one is viewed as an outcast, someone with no ambition for the good life and a firm start in life for one's children. A good education is so expensive, you know?

The weeding out process has now hit sectors A and B as well. Stocks Aa to Ae are roaring ahead, while the other five are beginning to reduce their rate of growth. In sector B the situation is even more unbalanced, with only Ba and Bb still rising at a good rate. Bc to Be are holding their own, but the other five are not doing well anymore at all. PE's of the top performers are now nearing 80, but very few people comment on these traditional measures of value. Everyone knows that a New Paradigm is firmly in place and that the future will show old measures of value are meaningless.

E1: This is it. Crunch time. If you do not do better this quarter you are out on the street. You sell all except what you own of Aa to Ae and Ba and Bb and bid aggressively to obtain a larger position in these stocks with what remains of your investments in non-performing companies.

E2: Your charts have shown some time ago that certain companies in sectors A and B were losing favour with investors. You adjusted your portfolio and is now almost fully invested in the 5 top performers of Sector A and the two in Sector B. The market is ticking along as expected and you should show good results for this quarter again.

E3: You now know that you cannot sit back for even a week, thinking that you are riding the winners. Things change just too often. To keep up with developments in the market you have a mobile real-time quote and you react within minutes to changes in the trends. To open and close a large position in a stock within 3-4 days is no longer out of the ordinary. Luckily turnover in these high performing companies is so high that it is quite easy to do. Provided one doesn't sit around waiting for a good price, but grab the offers the moment a new rising trend is noticed.

Scenario F: More and more voices are heard from people who compare the current market with historical bubbles. However, the lure of making money in a market that is now screaming upwards in leaps in bounds prove to be irresistible for almost all citizens. It seems so easy – simply look for any companies that performed well yesterday – particularly those with results coming out soon and buy. Even better, watch what is being tipped on TV or the internet and jump in early. Don't hold the position too long as an even better opportunity could come along any moment.

Attention in the market has now narrowed to only three stocks at a time. Coming from Aa to Ae and the two top B-sector companies, the market rotates among them in different combinations. Being on top of the news has become critical as the situation could change dramatically even in the course of a day. PE ratios are approaching 100, but hardly anyone notice this. Only the spoil-sports and the doomsayers do so and that is probably because they are all sitting on the sidelines with their funds in the bank, getting ever more envious of those who are making so much money.

F1: Your desperate change in strategy is paying off – your fund have gained only a little in the ratings, but the trustees know one cannot expect miracles in one quarter. At least they will give you another chance, even though there was no bonus. You are becoming an avid watcher of the financial channels and have a TV on your desk and a Bloombergs terminal.

F2: Your wall charts have long been replaced with a PC linked to the intra-day charts of prices on the internet. You have installed a direct line to your dealer at the broker and he and his team are assigned full-time to executing your trades. The top 5% is now in reach and then you can take a break for the around the world tour you have promised your family as reward for the long hours at work and studying the markets in the evenings.

F3: Suddenly your cares have (almost) disappeared. You are well established in the top 1% of fund managers and what you do in the market is observed and followed by millions. You are a frequent guest commentator on the financial channels and your website has a stream of hits day and night. It is now so easy to make money as you have financial resources that can move the market the way you want it to go. Life is fun! Except for the niggling thought that it could all go away overnight.

Scenario G: News has just been released of really outstanding results by company Aa and prospects of even better than expected growth for the next 5 years! Treeemendous! All other stocks fall in price as investors turn desperate sellers to free funds for investment in Aa.

G1: You desperately call your broker and scream, "Buy Aa at best! Sell the rest!"

G2: Your direct line gives you an edge and you manage to get your hands on even more Aa stock. Today your are going to make a killing. You will sell the rest later to free up the funds and are quite happy to carry half your purchase of Aa on margin until the rest of the funds become available. Or, you could even sell half later this afternoon and lock in the profit.

G3: You have been accumulating Aa stock for some time selling most of the rest in anticipation of this announcement. Now it has become time to lock in profit. After Aa hits a top the market has nowhere else to go but down. You sell all as the price jumps 10% on the previous close to reach a PE of 200 by midday, speeding up. This is it. You submit your resignation. Now you can retire and leave it to your successor to manage what lies ahead.

Discussion

This model is intended to illustrate through personal decision making that if a bull market lasts long enough without a period of correction in the economy to bring sanity to the market itself, and if there is some degree of differentiation in the economy – where one or two sectors display distinctly more promise than the rest, for whatever reason – a market bubble becomes almost inevitable.

It does not matter whether it is radio and the automobile manufacturers of the 1920's or the high tech and internet companies of the 1990's – if the market is differentiated in its performance, and anticipated performance far more so than actual performance, human nature will set in motion a process that ends in a market bubble unless interrupted by some other development.

The longer the economy and the stock market enjoys stability and good growth – with the focus remaining on the high performing sectors – the bigger the bubble will become.

And the greater and more far reaching and longer lasting will be the collapse.

For a very simple reason. The higher and more unrealistic the PE ratios of the few dozen favourites to have trended out above the rest of the market during the closing stages of the bubble, the greater the destruction of wealth when the prices of these stocks decline by 50% or 75% or even 90%. As the above model suggests, over time an ever larger proportion of total available funds is being concentrated in ever fewer top performing stocks.

The combined market capitalisation of the top 100 performers over the last few months of the bubble will probably be a significant percentage of GDP. Wipe out say 50% or even more of that amount and leave the debt that had been funded with investments in these companies as collateral, and you have a recipe for not only financial but also economic disaster.

Not something that will resolve itself over just a few months or with little fall-out elsewhere in the global economy, but something that could be far worse even than 1929. Because so many more Americans have raised so much more debt on the expectation that the bubble will continue to grow indefinitely. That Goldilocks has taken up permanent residence in the US and is on good speaking terms with the masters of the land.

In this exercise you had to assume the role of a fund manager whose reward is tightly linked to the performance of the fund. That is not too different from real life experience for fund managers, but the same exercise can be adapted with relatively little effort to apply to the individual investor who is trying hard to make some money on the stock market.

Rather than a reward based on a ranking in the order of funds to drive the individual, as it did the fund manager, it will be a comparison of his own performance to growth in the indices and, even more so, to how is friends and colleagues are doing that will gradually inspire the individual to become more aggressive in the market. No wonder so many people end up as day traders.

Using the traditional 80-20 rule, the progression shown in the alternatives to as scenarios develop over time probably applies to 80 of the investor population. Latecomers to the market will probably come in with more aggressive strategies in order to catch up on those who are already showing good returns.

The remaining 20% of the investor population – if it really is that many – are the ones who probably followed more conservative strategies, avoiding what they perceive as one day wonders, namely the stocks that suddenly burst onto the scene with excellent price performance, often not to maintain this for too long. Most of these people probably at some point in time decided that the market is getting overheated and that PE ratios of 30 or 50 or 75 or heaven forbid 120 are insane and that they should have their savings safely in the bank.

Or in gold.

Until, of course, the stupidity of remaining on the sidelines sinks in and the taunts of family and colleagues reach unbearable levels. Then the plunge is taken and all of the savings and all of the debt that can be raised is pumped into this crazy market.

Probably, in too many cases, just the week before the crash!

Conclusion In the above example, the story ends with only one stock – 1% of the market – reaches orbital speed and the really aggressive trader who have made a fortune bails out. How true to life that latter part is I do not know. What is true are the following:

• The A/D line has been in a down trend since April 1998. That was the start of the concentration of funds into ever fewer stocks, as described in this analogy.
   
• The S&P500, topped out at the end of 1999 and has since failed to rally to new highs.
   
• The Dow Jones reached its all-time high closing value in mid-January also, like the final rise in the S&P500, on sustained very high turnover, indicative of profit taking on a massive scale.
   
• The Nasdaq reached its all time high closing value (so far) on Thursday 10th February 2000. Turnover on the Nasdaq has been rising steeply, passing its previous high level around 1.5 billion shares a day to trade just below 2 billion shares a day. Also an indication of ever more frenetic trading activity as well as an indication of increasing profit taking.
   

This suggests that the cone of performing stocks, which became less than 50% of the number of stocks listed on the NYSE in April 1998, has gradually been reduced over time. The end – if it turns out to be so – came quite rapidly, with the S&P500, the Dow and the Nasdaq showing rapid degeneration with an ever decreasing fraction of all stocks carrying the bubble onward.

Further illustration is provided by the performance of these three indices during 2000. The S&P500 failed to make a new high after its top at the end of 1999. The Dow Jones dipped at first, but then rallied for a gain of 6.6% by mid-January, adding 2% to its own year-end top, to just outperform the S&P500.

Nasdaq also started the new year on a weaker note, but then rallied more than 20% into its high reached on 10th February, to be in a class on its own.

In the example presented above, the hypothetical market ended with only one stock carrying the flag forward at the end of the market bubble – 1% of that market. Surely that must have seemed really ridiculous as you were considering the final scenario to select one of the three alternatives?

On Thursday 10th February only four Nasdaq stocks were responsible for most of the 3% gain in the Nasdaq Composite Index that is the measure of performance for how many stocks – 4000? 5000 or are there 6000 companies listed on Nasdaq?

I do not have the facts at hand, but if you, the reader, felt some surprise at my scenario where only 1% of the stock market was responsible for the final surge in the market, consider that 4 stocks as a percentage of Nasdaq is substantially lower than 0.1%.

Could it be that reality in this case might just be imitating – and exaggerating – fiction?