What evidence do we have that the Stock Market may be in a bubble? originally appeared on Quora – the place to gain and share knowledge, empowering people to learn from others and better understand the world.
Bubbles are going to be difficult to spot if we stay focused on the wrong thing. Tourism spoils the beautiful things in this world?
2005 Japanese rally story
Back in 2005, Japanese equities market had a vertical rally. Zombie stocks were alive and well. In early 2006, CLSA hosted their traditional conference. Attendance was 3 times as big as the previous year. I knew this could not last when lunch rolled in. About a third of the people there could not eat with chopsticks. Hard to pretend You are a Japan specialist when You can’t down your lunch with the local cutlery.
Sure enough, Takafumi Horie got arrested on January 26, market tanked. Tourists packed up and left. Valuations came down.
Tourist participation and valuation irrelevence
The example above is reminiscent of Rockfeller and the shoe shine boy. When his shoe shine boy wanted to show Mr Rockfeller how smart he was, the magnate concluded that if guys who had no business being in the markets had bought, then there would be no-one left to buy and the next leg would be… down.
Same happened with the real estate bubble in the US. Everyone no longer saw their house as a home but as an ATM.
Same happened with tulips back then. People who had no business being in tulips got in.
As long as markets are dominated by professionals, things do not get out of hand. Professionals keep things orderly.
People who look at valuations to determine whether we are in a bubble make the implicit assumption that every participant understands valuations and fundamentals in the first place. Shoe shine boy, improvised Japan experts, Dutch gardeners do not understand any of this. Those unsophisticated participants are tourists. If their number is small, then pros still control the game.
When tourists dominate the game, then traditional measures fail. Tourists are overconfident, clumsy and ignorant. They do not play by the rules. They fall for the same routine over and over again: “this time it’s different”.
Bottom line, those who look at valuations to determine whether we are in a bubble look at the wrong thing. Symptoms of a bubble are tourist participation and generally accepted paradigm shift. In other words, when everyone comes in thinking there is easy money to be made.
How to trade bubbles?
“the story of humanity is the story of insanity”, Eckhart Tolle
Soros famously said that whenever he sees a bubble, he does not take the opposite side, he jumps on board but makes sure he gets off the train before it wrecks. It took me years to understand this.
The first mistake is to try and time the end of a bubble. Predicting the end of insanity is insane. As long as people think there is easy money to be made, suckers will be drawn like moths to fire.
Choices are therefore simple: get in or stay out altogether
Partial exit/risk reduction
That is the hard part. Sloppy entry can be salvaged, sloppy exit can’t. The first thing to do is neutralise risk by taking some money off the table/profit/risk reduction and let the remainder run its course.
The worst thing you can do is trust experts to predict the end of a bubble. Tourists run the show now. Experts will have you miss the big leg up.
Now, bubbles do not go parabolic up and vertical down. Tops are retested before the descent. When price hits a ceiling, then it is time to lighten up and/close the position.
Forget about valuations, forget about the commentators, The only thing that will tell you if market is going down is PRICE, nothing else
Are we in a bubble now?
Maybe we are, maybe we aren’t, it doesn’t matter anyways. This bull market is the longest in recorded history. Interest rates are also abnormally low. Money is free, so let’s party. Think of it as a bar: as long as drinks are on the house, no-one is going home, people will keep drinking.
Of course it won’t end well. Negative interest rates fuels complacency, but for now keep drinking
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