One of the most popular articles I’ve written is called Why do stocks go up and down. The conclusions it draws are not what you are going to hear on CNBC or from financial analysts. It’s uncomfortable to think that stock movements have no direct connection to what they call “fundamentals” unless a critical mass believes that and acts on it in the market.
To summarize my previous article with an example, let’s say a stock has a P/E ratio—a measure of the valuation of a company—that a critical mass of people think is getting too high. So, a lot of people put in sell orders and they outnumber those with buy orders. As we saw in my article, this can cause the price to move down. So, it’s not the high P/E ratio that made the stock go down, it’s that a significant number of people believed that it was too high.
This distinction is important and I’ll repeat it many times.
What is a bubble?
There’s no explicit definition of a bubble, but individual commentators and analysts believe a bubble is happening when stocks are “too high” relative to what they think they should be. Everyone has their own threshold for concluding we are in a bubble.
So, that establishes the fact that we’re in a bubble when people think we’re in a bubble. It’s circular reasoning but it’s true. Every individual investor makes that determination and buys and sells stock accordingly. If they buy because they think the runup is going to continue, they contribute to the runup. If they become worried about how high the market has gone, they may sell and contribute to the decline.
When is a bubble going to pop?
When you say a bubble has popped, this means that a run of significant gains are lost as the market declines, usually in dramatic fashion.
It’s important to note that no one can predict the stock market. No computer can predict the stock market. Some analysts may get on a hot streak and make a few predictions that were spot on, but it never lasts. If an analyst gets it right enough times, then they will be filthy rich and won’t be analysts anymore.
Historically speaking, the more that stocks go up, the more likely they are to lose some of those gains. It’s just a matter of the scale of those losses. It’s just human nature to think: Hey, I made a lot of gain here, let’s sell some of my stocks and preserve my gain. If enough people do that, the market will lose some ground.
For a bubble to pop, there must be panic. The market must go down enough that a significant number of people have an excessive worry that the bubble might pop. Note again that you must first believe that the market is in a bubble and that it’s popping.
As the market drops, the panic increases and the selling increases. Everyone has their own threshold for losing value on their investments and as it drops, more and more people pile on and the stock prices decline dramatically.
The simplest conclusion is often the most accurate. As of the date of this article, many are saying we’re in a bubble. I couldn’t tell you either way. But I can say that a degree in human psychology is no less important that what an analyst might say.
If an analyst says something, people either believe it or they don’t. If you believe it and make a buy/sell decision but few other people do, then you’re potentially going to lose out.
If the analyst causes enough people to believe them and they panic, you have a difficult decision to make. Do you try to get out before you get burned too much or do you hold steady and perhaps buy more shares after the drop?
I can’t tell you the answer to that. Some has called the stock market legalized gambling.
And it is.