The Madness of Crowds - 5 Signs of a Bubble Mindset.

The Madness of Crowds

Even in our lifetimes we’ve seen several financial bubbles such as stocks in the late 90’s or housing in the mid 2000’s.  So what is the psychology that propels the bubbles forward and how can we recognize when the end is nigh?  Here are some reliable indicators: 

New Rules - The old rules don’t apply.

When internet companies with no earnings and a handful of workers were selling for a billion dollars in the late 1990’s, some critics noted that the vast majority of these had no earnings and in fact were generating big losses.  The supporters shot back that the old rules of valuation (P/E ratios, ownership of stuff, patents) no longer applied and that we should use price/revenue or some absurdly high growth rate in order to estimate the value of an enterprise.  Some of these small companies did make it big but we can probably count them on one hand:  Yahoo, Ebay, Amazon, Google.  Most of the other tiny companies  declared bankruptcy or were gobbled up at low prices by one of the giants, leaving their investors with a few percent of their former values. 

Greed

When housing prices were going up rapidly in the early 2000’s and loans were as easy to get as a glass of water, people were buying multiple houses with nothing down in the hopes of flipping them in a month or 2 months with a 10% gain.  Some otherwise stable people saw the early practitioners of this approach make 10k or 20k a month, so they too jumped in.  When you see people jumping into a market just because they saw someone else make a lot of money in it, that’s a reliable sign that the end is near. 

Trend Following -  Everyone agrees that…

Think about it:  if everyone agrees that stock X is a great investment, then they’re probably already owners.  If you look around and there aren’t any more people on the sidelines or naysayers who could be converted to buyers, then buying will soon dry up and the correction will be hard and fast.   This secret has long been known to those who call themselves “contrarians”. 

Hockey Stick Graph

When you look at a price chart and it’s taking on the shape of a hockey stick, rising faster and faster to the point of being nearly vertical, beware.  Sure you’ll find pundits who will predict that it will go to a zillion dollars by this time next year, but do you really think that’s likely?   As soon as the curve starts to level out those who made money will feel that there are only small gains left to be had, and start to dump their shares. 

Runnning Out of Oil - (land, stocks, gold)

This argument usually goes something like “There’s so much money entering the stock market these days and very few IPO’s or companies issuing new shares.  There’s plenty of money chasing too few shares so they have to go up!”  This is usually the argument that you’ll hear on TV very soon before the crash.