Blow off top in the making?
Summary: Some you might have heard me talking about bubble scenarios and the Anatomy of a bubble. It is a topic I have discussed in detail during my Trading Psychology seminars and a topic I will talk more about in the future.
What is a bubble? In short:
- Bubbles look alike and has four phases; Stealth, Awareness, Mania and Blow off
- Stealth: Depressed mood, maybe from a previous collapse in market and economy. Not much interest, market direction almost flat/slightly up.
- Awareness: Mood slightly optimistic. Some professional and institutional investors enter the market.
- Mania: Everybody optimistic. Media overflown with positive news. Retailers jump in. Everybody wants a piece of the pie. Prices can only go up. FOMO: Fear Of Missing Out.
- Blow off: New paradigm/economy. Sky is the limit. And suddenly it all collapse.
- Usually a bubble consists of one or two larger corrections or as I call them; Pre-Peaks. Pre-peaks are bear traps or larger market corrections (min 15%) where there is big fear in the market about a new down turn. Sometimes there are two pre-peaks.
- There is no rule exactly where these pre-peaks are occurring in the life cycle of a bubble. However, it seems that if there is only one it is usually late in the Awareness phase, but if there are two pre-peaks, the first one is relatively early in the Awareness phase and the second one midway to towards the end of the Mania Phase.
When there are two corrections the first one is usually smaller in terms of percent than the second one with the last one.
- Finally, a blow off top where prices rises almost vertically with few down days.
During these four phases investor and trader psychology plays a major role in the build up to the top and subsequent implosion. That I will talk about in a later piece/webinar.Previous bubbles
Below is one of the most famous bubbles (and crash) in the financial markets, the Dow Jones Industrial in the 1920’s. You can see how there were two pre-peaks ie. major corrections. First one occurred early in awareness phase whereas the second one a few of months prior to the ultimate blow off top ie. in the stealth phase.
During the .com bubble there was only one Pre-peak/major correction (Index dropped 33% in two months) occurring late in the Awareness phase. After that the market sky rocket until it collapsed.
Are we in a bubble scenario?
It has been an ongoing discussion amongst Economists and Technical Analysts the past couple of years; are we in a bubble scenario? For sure some of the characteristics have been there but we needed at blow off top to perfect the scenario. Maybe that is what markets are warming up to.
With the new all-time highs in Nasdaq, Dow Jones Industrial and S&P 500 this could be the blow off top which could conclude the bubble scenario. As previously mentioned, a blow off top is an almost vertical move created by investors suffering from FOMO (Fear Of Missing Out). FOMO seems to dominate a lot of the market activity, as mentioned in these two articles
Apparently, there is a lot of money on the side line ie. in cash or short-term bonds yielding next to nothing.
And if you’ve got cash, where should you put your money in hope to get a return? Interest rates are low/negative, Commodities are not really moving or too risky and not easily tradable for most investors, which leaves equities as the only asset class. With new highs in many US Indices you don’t want to look like a fool staying on the side line. You are hit by FOMO.
A widespread FOMO could lead to a blow off top. Looking at the Nasdaq composite from 2010 and up to date (below) the Index certainly has a pattern that resembles many bubble patterns we have seen over the past 100 years in financial markets.
There is no strict rule for the time between last major correction and the blow off top.
However, when we see a bubble scenario*) with identical characteristics ie. two pre-peaks (two major corrections) as there seem to be here historically the Blowout top is concluded from a couple of months and up to typically 12 months after the pre-peak low. However, some do take longer but usually never more than 18 months **).Comparing Dow Jones 1920’s to today’s market
Would you be able to tell the difference between the Dow Jones Index 1923-1929 prior to the crash and the Nasdaq Composite? Or the Dow Jones back then and today? Not much difference.
*) Note: Bubble scenarios are not limited to longer term time ranges. Identical patterns are seen in abundance in any asset on any time range even intra-day.
**) Based on the numerous bubbles I have analysed in various asset classes.