How to recognise a bubble
I have been increasingly thinking about whether if we are in a bubble state as the stock market has surged sharply over the past month. This made me to do some research on ways to recognize bubble and the following is what I have found on the net .
How Bubbles Grow: 12 Easy Steps
1. A believable concept offers a revolutionary and unlimited path to growth.
2. Surplus of funds and lack of opportunities lead to buying or investing in anything available.
3. An idea is complex and cannot be totally explained or related to an investor.
4. The crowd imitates the leader. All Aboard! Even the gardener has a tip!?
5. Prices fluctuate from traditional level to overvalued level, THEN to all new ground and all time highs.
6. New levels are sanctioned by experts. "We are in a new Paradigm!"
7. Fear of missing the boat takes over. Cloning of the idea occurs as many new overvalued competitors enter the market.
8. Lending practices are eased. Money flows like water to anything or anyone with a new idea.
9. Cult figures emerge for the new paradigm. The media promotes lifestyles, not substance.
10. The Bubble lasts longer than expected. Critics are dismissed. The last suckers are sucked in.
11. Fraud emerges as partly responsible for the bubble as the first cracks show in the bubble.
12. Finally, everyone has a reason why it cannot continue. But nobody dumps, and all hold onto their profits. No new buyers. Market stalls.
How a Bubble Bursts
1. A continued new supply of lower priced offerings occurs from rising prices. New IPO's get bigger and bigger
2. There is a rise in interest costs. The Government declares "Excessive Exuberance" and tightens credit too quickly.
3. Prices collapse and everyone heads for the exits at the same time. With no more buyers, prices hit free fall.
4. Fraud is uncovered in many diverse industries, and in monitoring and auditing agencies. This leads to more selling.
5. Governments intervene and give investors time to get out before the real decline.
Rules to Live By
1. Do not extrapolate the future from the present.
2. Trends continue for a long time (2-5 years) and then suddenly reverse chaotically. Witness the Tech Bubble.
3. Intermittent secondary corrections occur at Fibonacci Levels of 38%, 50% and 62% that result in classic Bull or Bear Traps.
4. Bottom picking begins several different times, trying to restart the Bubble, but to no avail. Massive losses occur to professionals trying to manipulate the markets.
5. Finally everyone recognizes that "Trends go further than you expect, and last longer than expected." Everyone gives up and sells.
6. As the volume of the decline decreases, a slow recovery begins.
Above points taken from http://www.solerinvestments.com/Online-Trading/Stock-Market-Crash.htm
Despite personally worrying over the possibility of a bubble, I am still approximately 80% vested in the market now. Reason being, I believe there's more upside due to 1) lesser uncertainty over bank 2) more economic indicators showing it is recovering 3) Read some article mentioning a lot of cash are sidelined by fund houses meaning more fund will be flowing soon 4) Stock market is usually 3-4 months ahead of the economy.
Melynn Investment Experience
1. Stock Bought
Ezra (Singapore stock)
2 Reason for making the trades
This trade is mainly of a speculation type and there's no actual reason why I bought this. It is more of a random entry. Thoughts which flow through my mind before making the trade is to try to ride the strong intra day trend and this was derived based on looking at the speed the sell bid is cleared..
I intend to sell half of my positions within the clearing period(T + 5) and for the rest, I will set a cut loss at 3%. Eventually, I didn't stick to my original plan and sold them earning a total profit of 7%. Reason for not holding longer is because I am no longer comfortable holding such a larger position as I believe any type of negative news will trigger a massive selldown due to people taking profit from the recent surge.
This decision was made partially also because of the upcoming release of stress test results for US banks. Personally believe that a wave of bad news might be coming thus I would rather miss a profit than "blowing"(lose my capital) myself..
Points to ponder
- Am I risking too large of a position such that in the event a rare event happened , I wont have enough capital to pay up my losses. Some rare events might be stock suspension, bankrupt and etc.
I have risked quite a bit for this trade without considering the worst scenario. This is a point which I need to take note of for my future trades.
The stock market direction throughout the day is generally based on economic indicators, analyst comments , interest rates and etc (in short it might be random) therefore a trade which has been doing well in the morning might rock in no time for some reason. All these risk is something I need to take note of for my future contra trades .
Risks can be mitigated by i) Tight stop loss ii) Try to ride the profit but sell half of position when the situation is favorable (like 10% profit)
1) Considering the worst scenario
2) Time horizon too short
One most important thing I need to remember is to always differentiate investments and speculation. Never mix them together by holding on to losing trades which are of speculative nature.
Stock Pick (Google) Summary
This will be a page where i will be modifying weekly to update several values like stop trail, relative ratios, ATR as discussed in previous post.
Google as of 01/05/2009
Stock Price : US$393.69
Quantity bought: 17 shares
Price Paid : US$370.69
Total Cost (inclusive brokerage) : $9596.09
Brokerage Fee : $42.77
1R(Downside) = US$762(? of equity)
Highest Price since I entered the trade : US$403.75
ATR(50 day) : 13.925
Stop Trail : 399.82 - (3* 14.805) = 361.975
Fundamental relative valuation as of 01/05/2009
Stock | Industry | Stock's 5Yr Average* | |
Price/Earnings | 29.6 | 26.2 | 67.1 |
Price/Book | 4.4 | 5.9 | 10.5 |
Price/Sales | 7.1 | 5.3 | 13.6 |
Price/Cash Flow | 19.7 | 23.5 | 21.7 |
Dividend Yield % | --- | --- | --- |
Put/Call Open Interest (3 months)
- Based on the chart, it seems there are lesser interest on put options indicating optimism on stock. Might sell in strength later on.
Short Interest (3 months)
- Steep decrease in short interest thus indicating optimism as well.
Buy/Sell/Hold recommendations by analyst
FOR GOOG
| Strong Buy | 17 |
| Buy | 3 |
| Hold | 1 |
| Sell | 0 |
| Strong Sell | 0 |
- Gauge sentiment and potential buying demand. Currently very bullish thus it might be top heavy leading to heavy sell off. Need to take caution in this.