The Anatomy of a Market Bubble: Explained

The Anatomy of a Market Bubble: Explained

Posted on November 25, 2013

Canterbury Portfolio Thermostat - Weekly Update-11/25/2013

Current Market Environment: Market State 1: (last 30 trading days): Bullish/Rational Market State 1 is the most predictable of the Portfolio Thermostat’s 12 Market States (environments). The risk, while in MS 1, is typically around -2% to -4% from the previous market peak. Market prices tend to just keep inching higher in an orderly and rational manner. Investor psychology is typically muted or somewhat pessimistic. Thus, the coining of the phrase: "A healthy Bull markets will crawl a wall of worry.”

Canterbury Volatility Index (CVI) = 53 (rational market environment) The CVI was down 2 points from the previous week (decrease in volatility). As a point of reference, a CVI reading below 75 is considered to be a "safe zone.”

Based on our studies using market data beginning in 1970, we made the following observation. When the CVI is below 75, every maximum decline (highest daily peak to lowest bottom) has been less than -10%. Fluctuations from 8% to 12% are considered to be at the high end, of normal market’s noise (normal market fluctuations).

Market Comment: The S&P 500’s closed at another record high 1804.76 up a little over 6 points from the previous week’s close. Our overbought/oversold indicator currently 64% overbought. A slight improvement from the 68% overbought reading from the previous week (market neutral).

The S&P 500 has been up seven straight weeks. According to my analyst friend, David Vomund with Vomund Investment Management, that is a rare event. Since 1980, there have only been nine occasions where S&P 500 has advanced seven straight weeks. The S&P 500 has advanced nine straight weeks only three times. If the market is up this week, that would be eight straight. The S&P 500 is only up about 2.7% for the month. That said a normal correction could be good for the markets short term health.

The Anatomy of a Market Bubble: If I had a dollar for every time I have heard someone say the words "market Bubble,” during the last couple weeks, I could buy myself a new set of Titleist irons.

Markets are driven by only one thing and that is the law of supply and demand. Supply and demand is driven by investor’s beliefs about current and future market pricing. The more strongly and emotionally investors believe, what they think they know, the more likely the market could be experiencing a "Bubble.”

A "market bubble” occurs when prices rise at a "parabolic” rate (sharp advance during a short period of time). For example, many of you will remember the Dot-com Bubble and its impact on the NASDAQ 100 index. The NASDAQ was trading at 2688.17 on 10/19/99 and rose to 5048.62 by 3/10/00 for a total 87.8% increase in less than five months! THAT IS A BUBBLE.

The NASDAQ’s meteoric rise did not begin at a market bottom or an oversold environment. In fact, the previous NASDAQ’s cycle low was recorded one year earlier on 10/08/98 at 1419.12. That means the NASDAQ had already doubled once prior to the 87% rise in 5 months.

The Dot-com/NASDAQ Bubble popped when it declined nearly 40% in a little over two months, during the second quarter of 2000. The NASDAQ’s final bottom was registered on 10/09/02 at 1114. A total decline of -78%! THAT WAS A BUST.

Characteristics of a Market Bubble:

  • Prices are advancing at a parabolic rate.
  • Volatility is high and increasing. The indicators on our Canterbury Volatility Index (CVI) would have already turned bearish.
  • You would feel you were "missing out” if you were not participating in the booming market.
  • Investors begin to believe: "This time is different from the past.”
  • Investors are comfortable borrowing money (leveraging) to invest because the market will only go higher.
  • Irrational exuberance: "I have to get in NOW before it doubles again!” At this point, almost everyone has already invested their money. There are only a few left to buy and many potential sellers.

Characteristics of a Bursting Bubble:

  • The previously sharply rising market reaches a point when its rate of increase begins to slow. In other words, price cannot continue to advance at the same parabolic rate as before.
  • Short term corrections (declines in price) begin to get deeper and faster than previous corrections. The market continues to advance following the corrections.
  • Investors begin using the mantra "Buy the dips.” "I missed an opportunity to buy the last decline; I will not miss the next one!”
  • Short term market declines become larger and faster causing volatility to increase at an even faster rate than before.
  • Each following correction has higher and increasing volume. Each following advance will have lower volume, than the previous decline.
  • Investor psychology begins to shift from highly optimistic to: "I need to get out on the next bounce.” "I will get out when I can get my money back.” "GET ME OUT NOW!”

Is the US Stock Market Experiencing a Bubble? Bubbles occur when the percentage of investors who are Bullish (those expecting the market to go higher) are at an extreme. The American Association of Individual Investors (AAII) performs a weekly member survey that measures investor Bullish/Bearish sentiment. An extreme record high of 75% Bulls, compared to 13% Bears, occurred near the January 2000 Dot-com Bubble peak.

  • In contrast, last Wednesday’s AAII Investor Sentiment Survey actually the Bears leading at 38.5% and Bulls 31%. The US stock market is not experiencing anything resembling "irrational exuberance.”

The NASDAQ Bubble had a whopping an 87.8% increase in less than five months.

  • The current advance in the S&P 500 began on 10/03/11 at 1099.23 and closed on Friday 11/22/13 at 1804.76 which is about a 65% increase in a little over 2 years. In fact last Friday’s S&P 500 close is only about 18% higher than where it was in March 2000 (over 13 years ago) excluding dividends.

During the Dot-com Bubble, the Canterbury Portfolio Thermostat’s CVI (volatility) rose from the October 1999 low of CVI 86 to CVI 126 just prior to the Bust (historically 126 is relatively high).

  • The Portfolio Thermostat’s finished Friday at CVI 53, well below our volatility safe zone. In addition, the market’s CVI volatility has been decreasing over the near term, not increasing which is a primary characteristic of a Bubble.

BottomLine: The Current market environment has NO characteristics that would resemble a Bubble. Expect normal corrections typical of a healthy Bull Market. The Portfolio Thermostat will make adjustments in our holdings when the market environment begins to change.

Canterbury Investment Management would like to wish you and your family a Happy Thanksgiving.

Canterbury Investment Management: Tom Hardin

More About Tom Hardin

As Chief Investment Officer, Tom Hardin, Chartered Market Technician (CMT), makes all the final decisions on all investment and portfolio management decisions for Canterbury Investment Management. Tom has more than 30 years experience in the investment management industry and has broad breadth of knowledge. He is known as an innovator, educator and been revolutionary in the advancements in portfolio and risk management.

Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.