Thursday, 19 November 2009

Bulls and Bears: How Asset Prices Evolve

In last week’s post I mentioned three stages in the evolution of a market:
Identifying full-blown bubbles is easy. What’s not so easy is identifying the transitions that bookend a bubble. It’s not easy to know precisely when a rational, fundamentals-driven boom will morph into an irrational, sell-to-the-greater-fool frenzy. It’s not easy to know precisely when an irrational frenzy will reverse into an equally irrational stampede for the exits.
These three stages – rational boom, frenzied bubble, irrational panic – are in fact just three out of a total of six stages in my own idiosyncratic (and highly unscientific) taxonomy of bull and bear markets. Here’s how it works.

The first stage in any bull market is what I like to call the bounce. A sector or asset class that has been moribund for years or even decades suddenly starts rising in price. This could be due to exogenous shocks such as regulatory or technological changes; it could be due to Schumpeterian creative destruction, wherein prolonged low prices have driven out the weak and created a breeding ground for strong innovative companies; it could be due to simple cycles in supply and demand like the ‘commodity supercycle’. Whatever the reason – and often the operative reasons are not evident till many years later – prices begin to move upward. This is the bounce.

Typically during the bounce stage prices increase but the asset class remains unfashionable; only a few visionary investors recognize the bounce for what it truly is, the harbinger of a prolonged bull. Above all people don’t recognize the reasons for the bounce. Indeed, proselytizing for an asset class or sector during its bounce phase is a thankless job; you will probably get sniggered at by television talking heads for your trouble.

The second stage in a bull market is what I like to call the boom. During this stage, price rises have begun to attract more attention from the investment community. This is a stage of diffusion: the investment story spreads beyond its first few evangelists to an ever-increasing audience of relatively well-informed investors. To a large extent the strength of the sector becomes conventional wisdom. But prices continue to rise; it is not that contrarianism (going against the conventional wisdom) has failed; it is merely that the fundamentals continue to be so strong that they outweigh any technical factors.

The third and last stage in bull market is what I like to call the bubble. In this stage, the fundamentals have ceased to matter. In fact, the growth of the boom years has created sufficient supply to cause fundamentals to tilt to the opposite direction. But nobody notices. Drawn by strong performance, ever more investors flood into the sector. High prices create their own self-reinforcing dynamic. Positive feedback, mass self-delusion, ‘this time it’s different’, new paradigm stories, ‘permanently higher plateaus’, huge quantities of supply, sectoral employment shifts, dodgy startups, reality TV shows, easy funding – these are all symptoms of a bubble phase.

It’s pretty easy to distinguish between the three stages of a bull market. Certainly nobody could mistake a bounce stage (in an obscure and unfashionable sector) for a boom stage (where the sector is widely known for its strong fundamentals, albeit less widely invested in). Still less could anybody mistake a boom for a bubble: in a boom the fundamentals still rule, in a bubble fundamentals have gone out the window and the greater-fool theory rules. (Though well-meaning but misguided analysts inevitably try to justify bubble-era prices and try to coax the market into some sort of fundamental-based story; this usually involves invoking a new type of fundamental).

Just as a bull market has three stages, so too a bear market. The three stages of a bear are fairly accurate mirror images of their bull correlates.

First comes the blowup, in which the excesses of the bubble are purged. This purge is often quite dramatic, as the positive feedback loop that fueled the expansion reverses direction, causing prices to fall as precipitously as they previously rose. The excess liquidity that helped inflate the bubble is withdrawn with quite astonishing rapidity, leading directly to various closely related phenomena that are emblematic of a panic: the flight-to-quality reflex, the cash-is-king psychology, and the dynamic of the liquidity-death-spiral.

The next stage in the bear market is the bust. This is a long drawn out decline in prices as the market works out its overhang of excess supply (created in the boom) and anemic demand. The bust can last for years or (if markets are not allowed to clear) even decades.

The final stage of the bear market is the bottom. This is not a single point but a very lengthy period in which investor interest wanes, volumes and volatility decline, and sector news gets relegated to the inside pages of the financial dailies. Of course the bottom merely sets the scene for the next stage in the market, the bounce of the next bull market. And thus the circle is complete.

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