What Is Technical Analysis and Why Use It? Part 2

Anatomy of a Speculative Bubble

In a 'normal' liquid market, there is a balance between buyers and sellers. When there is an imbalance of buyers and sellers, market prices rise or fall. If the strength of the buyers outweighs that of the sellers, the market will rise. It will keep rising until the buying pressure has been exhausted. If the sellers are the stronger group, the market will fall.

Manias occur when the vast majority of traders want to buy at once. Crashes occur when the vast majority of traders want to sell at once.

Let us examine a few examples of human greed that drove markets to levels, which bore no resemblance to the fundamental value of the underlying commodity. These examples also illustrate why it is dangerous to assume that human beings behave in a rational manner when making trading or investment decisions.

From time to time, the effects of crowd behaviour can be observed in market action. An excellent example occurred in Holland in the 1600's. Today it is often referred to as 'Tulip Mania'.

Tulip Mania of the 1630s

The people of Holland became obsessed with tulips in the 1630s. Rare tulip varieties were discovered, propagated, and sold for higher and higher prices. At their peak, the owner of one Samper Augustus bulb was offered 12 acres of land in exchange for a single tulip bulb and another Tulipe Brasserie bulb was exchanged for a profitable brewery in France!

Eventually government intervention halted the mania, and prices crashed in 1637. Fortunes were lost in a matter of days.

Mackay, in his classic book Extraordinary Popular Delusions and the Madness of Crowds, first published in 1841, concluded that entire communities could be deluded in the pursuit of easy wealth.
"We find whole communities suddenly fix their minds on one object, and go mad in its pursuit; … millions of people become simultaneously impressed with one delusion…"
(Preface, Extraordinary Popular Delusions and the Madness of Crowds.)
Tulip mania is but one example of the greater fool theory in operation. Sane and intelligent people willingly pay ridiculous prices for something, in the hope that they will eventually be able to sell the commodity for a much higher price to an even bigger fool.

In reality, the chart of tulip bulb prices is a chart typical of a 'bubble', or 'speculative mania'.

From a trader's perspective, speculative bubbles have led to many people making a great deal of money, trading both on the upside and on the downside. Many inexperienced traders, however, have lost large sums of money, being lured into the market when the emotion of greed was at its peak near the ultimate top, and then not recognising the telltale signs that the party was over. After the crash, they find themselves with large losses and a lesson in mass psychology that commanded a very high tuition fee

The South Sea Bubble of the 1700s

The South Sea Bubble was another well-known example of human greed ultimately resulting in human misery. The history of the South Sea Bubble is somewhat complex. The bibliography presented at the end of this article lists some books to read - and some of these classics were written centuries ago!

Whereas tulip mania involved greed driving up the price of tulip bulbs, the South Sea Bubble involved the formation of companies and the trading in their shares. At the peak of the bubble, members of the public were clamouring for shares in companies for the:
 Trading of hair;
 Importation of jackasses from Spain;
 Extraction of silver from lead; and
 Manufacture of a perpetual motion wheel.
The most ridiculous was a company that sold 100 pound shares. People paid a two percent deposit, with a guaranteed return of 100 pounds per annum. What was the nature of the company's business? It was to be "a company on an undertaking of great advantage, but nobody to know what it is." (That sounds a little like some of the Internet companies - but, of course, it couldn't happen today, could it?)

In this example the shareholders in this company lost everything. The underwriter disappeared with the money.

Sir Isaac Newton was reported to have lost some 20,000 pounds speculating in bubble stocks. He was later to say: "I can calculate the motions of heavenly bodies, but not the madness of people".

The Florida Land Bubble

In the early 1920s Florida land prices rose exponentially, and ultimately crashed. The bubble started when farmers bought Florida land in order to enjoy the warm winters while their land was dormant. The farmers were later followed by city dwellers and prices started to increase rapidly. At the peak of the boom, one third of the people living in Miami were real estate agents.

Houses were built at an ever-increasing rate, and once almost worthless swamp land became very valuable. The bubble burst when a hurricane destroyed many houses.

Groucho Marx lost a very large sum of money in the resulting crash and found it to be anything but a laughing matter.

The Stock Market - 1929

The roaring 20s was certainly a decade for speculation. Everything seemed to be booming. The hit song written in that decade which best describes it was 'Happy Days Are Here Again'. Celebrities like trading genius Jesse Livermore, and the 'World's Greatest Entertainer', Al Jolson, were all at their peak.

The Dow Jones Industrial Average had risen to a peak of 381 on 3 September 1929, and the well-known stock RCA had risen from $94 to $505 in just 18 months. Happy days were indeed here again.

All speculative manias must end. The stock market crashed in late October 1929, with the real erosion of prices occurring in the run down to the final bottom in 1932. From its peak of 381, the Dow fell to 41.

RCA, which had peaked at $505 in 1929, traded at $2 in 1932. For those who believed in a 'buy and hold' strategy (as opposed to following a clear sell signal), all was not lost. Those who bought at the top could have waited for the stock to recover, and it did - had they been willing to wait 67 years!

The 'Tronics Boom

In the early 1960s a boom occurred in so-called technology stocks, particularly those with 'trons' (such as Transitron, Astron and Vulcatron) or 'onics' (such as Supronics, Circuitronics and Electrosonics) in their name. Speculators and fund managers alike aggressively accumulated these stocks.

The bubble burst in 1962. Many stocks later sold for less than 10 percent of their peak price.

The Poseidon Boom

In Australia, the nickel stock boom of the late 1960s resulted in some nickel stocks experiencing spectacular increases in price. The best known, Poseidon, rose from $1.85 on 26 September 1969 to its high of $280 on 10 January 1970. Some years later it went off the board. Its shares were worthless.

The Stock Market - 1987

1987 produced another stock market crash. Like 1929, it was a period when much borrowed money was used to buy stocks. It was also a period when stock index futures were used for speculation, and program trading became a way to 'easy' money. Unlike 1929, the world did not plunge into depression. In fact, the United States stock market took only a couple of years to exceed its 1987 peak. The Australian stock market, however, took more than 10 years to exceed its 1987 peak.

The Internet Boom

The late 1990s and early in the Year 2000 saw many stocks associated with the Internet achieve exponential increases in price. Like all previous speculative bubbles, greed quickly replaced logic.

One example of the rise and fall of the dot.com fortunes was the case of two men in their early 20s who both became overnight millionaires when they floated their Internet company Theglobe.com.

The share price of Theglobe.com gained 606% on the first day of trading. Such price increases are clearly non sustainable. Since the peak, the price of Theglobe.com shares has fallen 98.5 percent.

Since the dot.com bubble deflated, more than 100 United States Internet companies have ceased trading, or are in serious trouble and are desperately looking for new sources of finance. The Law of Gravity has not been repealed - even in the Year 2000.

Just as 'tronics' added to a company name sent stock prices skyward in the Tronics Boom, in the late 1990 companies clamoured to become, or to be perceived as being, Internet stocks. It was dot com mania. As with all manias, when a chart looks like an exponential growth curve, and a trend line of the most recent market action rises at an almost vertical angle, the end is near.

As the market became more and more overheated, experienced traders started to see the danger signs. Did you observe the following?
 The number and size of new Internet floats (initial public offerings)? Few owners would float their company in a very weak market. As a strong bull market matures, the number of floats, per month, start to rise rapidly.
 The spectacular success of many floats, and the accompanying reports that people were making 'easy money'?
 The television coverage of children making thousands of dollars trading the stock market.
 The coverage of the new breed of so-called day traders who resigned from their jobs to trade full time.
 Talk of 'old' versus 'new' economy stocks, somehow suggesting that you had to purchase the new economy stocks to be 'cool'.
 The playing down of the importance of company earnings in justifying the price of so-called new economy stocks.
 Charts, such as the Nasdaq chart, rising in a parabolic manner to a point where its final trendline on a daily chart was almost vertical.
 And so on