Showing posts with label panic or bubble-bursting situation. Show all posts
Showing posts with label panic or bubble-bursting situation. Show all posts

Sunday 23 July 2023

How to identify potentially threatening asset price bubbles?

In a globalized world, with few barriers to capital flows, investors around the world can bid up prices for stocks, bonds and real estate in local markets from New York to Shanghai.  

Central banks have fueled these purchases with record low interest rates and by entering the bond market as major buyers themselves  

Largely as a result, global financial assets (including only stocks and bonds) are worth $280 trillion and amount to about 330% of global GDP, up from $12 trillion and just 110% in 1980.


Traditionally, economists have looked for trouble in the economy to cause trouble in the markets.  

They see no cause for concern when loose financial policy is inflating prices in the markets, as long as consumer prices remain quiet.  

Even conservatives who worry about easy money "blowing bubbles" still look mainly for economic threats to the financial markets, rather than the threat that overgrown markets pose to the economy.   

But financial markets are now so large, that the tail wags the dog.

A market downturn can easily trigger the next big economic downturn.


Summary:

The general rule is that strong growth is most likely to continue if consumer prices are rising slowly, or even if they are falling as the result of good deflation, driven by strengthening supply network.

In today's globalized economy, in which cross-border competition tends to suppress prices for consumer goods but drive them up for financial assets, watching consumer prices is not enough.  

Increasingly, recessions follow instability in the financial market.  

To understand how inflation is likely to impact economic growth,  keep an eye on stock and house prices too.



Housing bubbles and Stock bubbles fueled by borrowings

Be alert when prices are rising at a pace faster than underlying economic growth for an extended period, particularly for housing.  

  • Home prices typically rise by about 5% a year.  
  • This pace speeds up to between 10% and 12% in the two years before a period of financial distress.
  • Once prices for stocks or housing rise sharply above their long-term trend, a subsequent drop in prices of 15% or more signals that the economy is due to face significant pain.  

In general, housing bubbles were much less common than stock bubbles but were much more likely to be followed by a recession.  The downturn is much more severe if borrowing fuels the bubble.  

  • When a recession follows a bubble that is not fueled by debt, 5 years later the economy will be 1% to 1.5% smaller than it would have been if the bubble had never occurred.
  • If the investors borrow heavily to buy stock, the economy 5 years later will be 4% smaller.
  • If they borrow to purchase housing, the economy will be as much as 9% smaller.


Thursday 20 January 2011

Market Behaviour: Irrational Exuberance

When a bull run goes on for too long, it can morph into irrational exuberance.  People tend to think that the market has changed and that stock will continue to go up forever.  In reality, it won't - instead, a stock market bubble is gradually inflating.

Unfortunately, most people get caught in the hype and continue to buy while the bubble continues to inflate.  Then that bubble bursts without warning, sending shares of stock down 50 percent and more.  Asset bubbles have formed repeatedly over time, but most people can't recognize a bubble until after it bursts.

The most recent stock bubble was the Internet stock bubble, which inflated in the 1990s and burst in the early 2000s.  Many people who got caught up in Internet stocks lost 50% to 70% on their portfolio - and some lost as much as 90%.

Value investors such as Warren Buffett didn't play in that market.  Value investors will not buy a stock that doesn't have a proven cash flow.  Internet stocks were losing money every year.  Most hadn't even figured out how they would make a profit.  Yet analysts recommended them based on future earnings projections.

If you can't figure how a company will generate its cash flow, walk away from it.  Don't ever get caught up in promises of future earnings that have not yet materialized.



Related topics:

Tuesday 1 June 2010

Panic-Resilient Stocks

There are several groups of stocks that tend to act well in a post panic environment, especially if the crash itself drives prices to incredible levels.  Of course, the more unusual the values created, the quicker is the upside correction.  Some of the groups most likely to snap back are:
  1. Recession-resistant industries (foods, drugs, utilities).
  2. Noncyclical blue chips driven well down (oils).
  3. Big names with corporate staying power (AT&T, Exxon, General Electric and General Motors).
  4. Fortune 100 and similar companies with good yields.
  5. Trade-down concepts like low-cost restaurants and discount retailers (recession "beneficiaries").
  6. Companies with low P/Es or low price/cash flow ratios not in the first list here.
  7. Companies selling below book value and with positive earnings estimates for the coming year (implying credibly sustainable book values).
  8. Companies with low debt/equity ratios.
  9. Unleveraged closed-end, non-junk bond funds.
  10. Panic-trigger beneficiaries (e.g., oil-service and insulation stocks after OPEC raised oil prices in 1973).
    All of these stocks are recession-resistant or perceived as among the most likely to survive hard times.  They retain market sponsorship and regain enthusiastic buyers soonest.  Related positively to the trigger event, they have high visibility because investors remember the concept vividly.

    It is important to make hold/sell calls in the light of prevailing market expectation and not personal judgement of what may happen.  If the (correct) bet is no recession, the reward is smaller and slower than if the (correct) bet is market expectation of a recession (whether it comes or not).  The investor must subject his ego to the realities of the emotional climate.  It is better to be rich than to be vindicated slowly.



    Stocks that don't fare well in a post-crash environment

    Stocks that don't fare well in a post-crash environment

    Stocks that tend to be sub-par performers in a post-crash environment are:
    1. OTC issues
    2. Low-priced stocks
    3. Small total-capitalization issues
    4. Thinly-traded, under- or non-covered stocks
    5. Industry laggards
    6. Recession-sensitive by industry
    7. Discredited groups
    8. Panic-trigger related groups

    Because of fear, nervousness and lack of speculative appetite after a crash or panic, the first five groups (some of which overlap) lack sponsorship.  

    In addition, because market panics generate immediate scare headlines in the media, there is talk of recession and parallels drawn with 1929.  So recession-sensitive stocks by industry do not bounce back much for a period of time.

    There may, in fact, be no recession following the market's downmove (as in 1988), but perception and expectation drive prices near-term more than facts do.  So cyclicals like steels, chemicals, paper and capital-good producers are not solid choices for participating in the bounce.  Similarly, vacation and luxury stocks fare poorly.

    The discredited groups vary from one market period to another.  Their identity depends on what was in the headlines in recent months.

    • Basic industry stocks were taboo in the early 1980s, known as the 'rust-belt' period.  
    • High-tech stocks suffered through a private, one-industry recession in the mid-1980s.  
    • Banks were whipping boys in the early era of bad third-world loans.  
    • Most recently, savings and loans have been in the doghouse due to bailout legislation and highly visible failures and scandals.

    Again in a longer-term perspective, the facts may prove that the fear about leading companies in discredited groups was unfounded.  But in the short term after a crash there are few who have the courage to sponsor tarnished-image stocks with either money or written advice.  Such issues are early recovery laggards.

    The final category should be off the hold list for similar reasons.  Sometimes there is an industry or category of stocks related to the news that triggers the panic selling.  

    • In 1962, it was steel stocks sensitive to pricing confrontation with the Kennedy administration.  
    • Brokerage stocks would have been poor choices to hold after the 1987 crash because of all the controversy surrounding program trading.  
    • The 1989 crash was triggered by the collapse of the propose buyout of UAL, Inc., so airlines and other proposed leveraged buyout candidates were identifiable as the trigger-related group at that time.

    Weathering a Panic

    The central concept applicable to the 'buy and hold until fundamental changes' investor is the occasional need to play when it is painful.  But this concept specifically and only means to hold stocks that are being affected just by the overwhelming negative psychological forces that occasionally cause selling routs or panics in the whole market.

    To put this very important limiting caveat another way:  when a crash or panic occurs, stocks should be 

    • held only if they are going down because of market factors and 
    • not if they are being affected by company factors.  
    This should relate to only a few issues, however, because investors following a disciplined selling methodology (see related article below) already should have weeded out the bad performers and taken profits on the stellar performers well before a bear market reaches climax proportions.

    So when appropriate selling has left an investor with only a few, high quality stocks, he can and should hold onto the gems and play through the difficult experience of a panic or crash.  He will be holding only a relatively small portfolio (having followed the other cashing-in suggestions well before the bottom nears), so his level of pain will be no worse than moderate.  And his cash holdings will give emotional comfort and provide the resources for acquiring stocks advantageously when prices get really low.

    Some investors may see a contradiction in this advice because they were usually counseled that avoiding losses is the first priority and the best reason for selling.  But taking a short-term dose of paper losses in a crash - by holding quality issues - is a lesser risk than selling out during the fury, and hoping to have the courage and good executions to get back in at lower prices shortly afterward.

    If an investor is down to just a few core holdings anyway, he is better advised to tough it out.   The very experience of playing in pain through a temporary crash (think of the October 1987 and October 1989 bashings) is of enormous instructional value despite the modest monetary cost involved.  The process of crisis-thinking and the need to make wrenching decisions that prove valid in short order will serve him well for the rest of his investment career.

    Once he has successfully navigated the worst of the choppy investment seas, he will have learned survival lessons and will have internalized feelings and taken in an experience that will be forever his.  That experience deepens his understanding of the way the market works.  Probably most of all, having won at a different game, he develops the wisdom and courage to succeed in similar circumstances in the future.  And that provides the opportunity to make big profits in the handful of similar opportunities that will occur throughout the rest of his investing career.  He will know beyond any shadow of a doubt that the contrarian philosophy of investing works.

    When caught in a panic, the central question is whether capitalism in the United States and major Western democracies will continue to function after the panic ends.  If the answer is yes, then there is no reason to sell at foolish levels.  In fact, the only rational thing to do is take courage and make buys.  Being gutsy enough to act on the contrarian test - refusing to sell good stocks cheap because Wall Street and Main Street have lost faith for a few days - insures appropriate selling.  It is difficult to buy in a panic.  Those who can do so are rational enough to sell with discipline as highs approach.

    There is one more qualifier on whether to hold or sell after a panic has passed.  Once the panic subsides, there is a lift in the market.  But the effect is significantly different on various kinds of stocks.

    • For some issues, there is a sharp snap-back rally; 
    • for others, there is very little improvement.  
    Just as it is not advisable to sell into the panic, it is prudent to reassess positions after the selling frenzy has subsided and the lift in prices has begun.

    The object, as always, is to decide what to sell and what to hold.  Selling should not be urgent because pre-bear-phase tactics will have raised a lot of cash, so there's no need to sell to raise cash for margin calls or buying.  But because the goal is always to maximise return on capital and to take advantage of the time value of money, look closely at what to hold and what to sell after the panic has cleared.


    Related:

    To hold or to sell? Holding should occur only if no tests for selling are failed.

    Wednesday 30 December 2009

    Be patient: Wait for opportunities during correction or panic during a bull market

    Great Opportunities to buy companies with durable competitive advantage

    a) Correction or panic during a bull market:

    Any company with a durable competitive advantage will eventually recover after a market correction or panic during a bull market.

    b) Bubble-bursting situation:

    But beware. In a bubble-bursting situation,during which stock prices trade in excess of 40 times earnings and then fall to single-digit PEs, it may take years for them to fully recover.

    After the crash of 1997, it took until 2007 to match the 1990s bull market highs. There are still companies trading today at below their last decade high price. On the other hand, if you bought during the crash, as Warren Buffett often did, it didn't take you long to make a fortune.

    http://myinvestingnotes.blogspot.com/2009/10/opportunities-to-buy-companies-with.html

    In the aftermath of the bursting of the bubble

    The Aftermath

    In the aftermath of the bursting of the bubble, you initially find investors in complete denial. In fact, one of the amazing features of post-bubble markets is the difficulty of finding investors who lost money in the bubble. Investors either claim that they were one of the prudent ones who never invested in the bubble in the first place or that they were one of the smart ones who saw the correction coming and got out in time.

    As time passes and the investment losses from the bursting of the bubble become too large to ignore, the search for scapegoats begins. Investors point fingers at brokers, investment banks and the intellectuals who nurtured the bubble, arguing that they were mislead.

    Finally, investors draw lessons that they swear they will adhere to from this point on. �I will never invest in a tulip bulb again� or �I will never invest in a dot.com company again� becomes the refrain you hear. Given these resolutions, you may wonder why price bubbles show up over and over. The reason is simple. No two bubbles look alike. Thus, investors, wary about repeating past mistakes, make new ones, which in turn create new bubbles in new asset classes.

    http://myinvestingnotes.blogspot.com/search/label/phases%20of%20bubble

    Tuesday 13 October 2009

    Great Opportunities to buy companies with durable competitive advantage

    a) Correction or panic during a bull market:

    Any company with a durable competitive advantage will eventually recover after a market correction or panic during a bull market.

    b) Bubble-bursting situation:

    But beware. In a bubble-bursting situation,during which stock prices trade in excess of 40 times earnings and then fall to single-digit PEs, it may take years for them to fully recover.

    After the crash of 1997, it took until 2007 to match the 1990s bull market highs. There are still companies trading today at below their last decade high price. On the other hand, if you bought during the crash, as Warren Buffett often did, it didn't take you long to make a fortune.

    Stock market creates buying opportunities

    The bull/bear market cycle offers many buying opportunities for the selective contrarian investor.

    The most important aspect of these buying opportunities is that they offer the investor the chance to buy into durable-competitive-advantage companies that have nothing wrong with them other than sinking stock prices.

    The herd mentality of the shortsighted stock market creates buying opportunities.

    Wednesday 3 June 2009

    Company Recovery after a correction, panic or bubble-bursting situation.



    1. Companies with durable competitive advantage

    a) Correction or panic during a bull market: Any company with a durable competitive advantage will eventually recover after a market correction or panic during a bull market.

    b) Bubble-bursting situation: But beware: In a bubble-bursting situation,during which stock prices trade in excess of 40 times earnings and then fall to single-digit PEs, it may take years for them to fully recover. After the crash of 1973-74, it took Capital Cities and Philip Morris until 1977 to match their 1972 bull market highs. It took Coca-Cola until 1985 to match its 1972 bull market high of $25 a share. On the other hand, if you bought during the crash, as Warren Buffett did, it didn't take you long to make a fortune.



    2. Companies of the price-competitive type

    Be warned: Companies of the price-competitive type may never again see their bull market highs, which means that investors can suffer real and permanent losses of capital if they buy them during a bubble.



    Take Home Lessons

    The bull/bear market cycle offers many buying opportunities for the selective contrarian investor.

    The most important aspect of these buying opportunities is that they offer the investor the chance to buy into durable-competitive-advantage companies that have nothing wrong with them other than sinking stock prices.

    The herd mentality of the shortsighted stock market creates buying opportunities for both you and Warren.