Madness and mania in the stock market

Are stock markets, which are very close to their all-time highs, being propelled by an extreme state of euphoria by investors, who are engaged in a classic mania? And can stocks be said to be in a bubble?

There are plenty of analysts that maintain that today’s stock valuations are not outlandish (the ‘new normal’) and are entirely justified. To me, this seems to be wishful thinking – they are disregarding evidence, because they want to believe this is the ‘new normal’.

So today, I want to tell you why I believe that stock markets are indeed in a bubble.

This is what happens when the herd goes haywire

Let’s turn to the (Webster’s) dictionary definitions so that we all can agree on what I mean.

“Mania: an extreme enthusiasm for something that is usually shared by many people.”

“Euphoria: a personal feeling of great happiness and excitement.”

Euphoria is felt by the individual, while a financial mania is a manifestation of a large group of euphoric individuals (a herd).

One of the notable features of a herd mania is that the members disregard every piece of evidence that contradicts their core beliefs – sometimes violently. The word mania has the same root as madness – and indeed, a mania is a kind of madness, where the collective mind of the herd goes haywire and divorces from reality.

One of the classic books on the subject is Charles Mackay’s Extraordinary popular pelusions and the madness of crowds. In the financial arena, he tells the stories of the South Sea Bubble and the Holland Tulip Mania – these are both well-known cases of extreme mania – and introduces the term bubble for a financial mania.

Sir Isaac Newton’s nightmare

The South Seas Bubble was basically a scam that was bought hook, line and sinker by investors (pun intended), providing an early example of how greed can easily trump rationality on an industrial scale (for that time). Even the mighty intellect, Isaac Newton, father of gravitational theory, was taken to the cleaners.

Here is a chart of Newton’s exploits as a stock picker:

South Sea bubble chart

Evidently, he hadn’t considered the possibility of gravitation working on stock prices. Incidentally, according to the chart, the high was a little short of the round-number £1,000 level. I can imagine this was a widely-touted forecast on the way up to the 1720 high and served as a lure to bring more investors in. That is what these round-number forecasts do. It is a call to ‘buy me’.

I have found near-misses of a round number target are a very common occurrence. Remember the $2,000 forecast for the gold mania in the period up to 2011? The high fell short of that forecast too. And I covered the recent near-miss of the $1,400 level in gold in March this year.

The shape of the above chart is entirely typical of a mania stock – straight up and then straight down. But the shape applies to only one type of stock – one that has little tangible value behind it (in less technical jargon, a scam).

There were many such ‘faith’ stocks in the dot-com mania of the 1990s. I recall reading many online chat rooms at the time that were filled with wildly euphoric posts. It was eyeballs that counted, not profits. What utter madness.

In the rally phase, bullish sentiment grew as the market rose. Imagine an investor buying in the £100 – £200 range, as Newton did. As the market passed the £500, then £700, then £900 levels, he or she would naturally feel more and more euphoric.

What an investing genius I am! It’s going to £1,000 for sure – and maybe to the moon! I’m buying more. And Newton paid the price.

A good investor goes against the herd

As I maintain, a good investor should become more bearish as prices rise.

But for assets that do have tangible value, such as the major stock indexes, whose component stocks are profitable and dividend-payers, the shape of the typical top is nothing like this. Here, tops are rounded affairs, because a top marks the transition from hope (up) to a gradual realisation that the hope will not be realised.

That is where the faithful refuse to see the game has changed and will hang on until they are forced to sell, usually at much lower prices, as Newton did. It is this relentless long liquidation that produces the steep falls that stand out on the charts.

I read many pundits who are calling for a ‘melt-up’ prior to any lasting top. This is most unlikely, as history is bereft of such patterns. In the major stock indexes, dips are usually bought as investors see a chance to grab shares ‘on the cheap’. This produces the deep upward retracements we commonly see.

Don’t ignore the evidence – this is a mania

In Friday’s post, I showed the pattern of the Russell 2,000 at its A wave top and in its current C wave top. Both are rounded and not at all spiky.

However, major bottoms are totally different affairs. Here, we usually see huge spikes at the lows. The example of March 2009 is a vivid example. This is because the low is the transition from total despair (down) to hope (up) as investors really do grab shares on the cheap and there are few sellers left there.

Today, with the stark divergence between economic conditions (weak) and booming stocks, there is undoubtedly a high degree of euphoria out there – and a madness that I can call a mania. Volatility is extremely low, indicating huge complacency towards a major decline. This is a perfect set-up for such an event.

I believe we are at an historic turning point in sentiment towards stocks. Naturally, the army of pundits will be trotting out the ‘reasons’ for the turn, such as Iraq, pending interest rate increases, and so on. These will only appear well after the event, of course, and provides exciting reading which sells newspapers.

Sadly, reading about it afterwards cannot give us any profits: we must be positioned well before it appears in the news.

What the Dow is showing

Last week, I covered the small-cap Russell 2000. This morning, I will show the large-cap Dow, which sports a magnificent pattern:

Dow Jones spread betting chart

On the hourly chart, this is the wedge pattern that has been building since the February low – and a classic wedge it is. I have a PPP (prior pivot point) on the upper line and three accurate touch points. On the lower line, I also have three accurate touch points. This makes the support and resistance lines very reliable.

Within the wedge, there is a pretty five-wave pattern. This form is typical of a reversal pattern. The large negative-momentum divergence also adds to the evidence of a major reversal.

A break of the lower line would really set the bulls’ fur flying!