8-01 Manias, Bubbles, and Crashes
All the way back in chapter 2, we talked about How The Stock Market Works, and the concept of Bull Markets and Bear Markets. Both concepts relied heavily on “Supply and Demand” – new investors increasing demand causing prices to go up, and investors selling off their shares and leaving the stock market causing prices to generally go down.
Supply and Demand, Out of Control
Manias, Bubbles, and Crashes are what happens when these basic economic actors of supply and demand start spiraling out of control. These three concepts are all related:
Manias
A “Mania” is the first phase to look out for. “Manias” are defined as when investors start all buying into the same stock, solely because they see the price is going up. It can be very hard to tell when a mania is beginning, because it is usually triggered by the same actions that cause regular price movements.
Maybe a company beat the analyst’s earnings estimates 3 quarters in a row, and investors think they might have a winning formula. Or maybe a new product was announced that triggered the price to start rising, and other investors are trying to pile in. Whatever the original cause, new investors are buying up shares of the stock solely because they see the price is already on an upward swing. Out of fear of “Missing Out” few people are willing to sell because their investment is already paying off. This starts driving the price higher and higher in a very short period of time.
You can usually spot a “Mania” compared to just “price increases” by the volume. We used an example of Amazon (AMZN) beating an earnings estimate in the previous chapter causing a boost in price:
The line chart on the top shows the price, while the blue bar chart on the bottom shows the volume for that day. On July 31 is when they announced beating the estimate, which caused an increase in price, and a small increase in volume, but nothing too crazy compared to trading the days before.
Now compare this against Energous Corp (WATT), in December 2017 – January 2018:
On December 27, this company announced a new patent for a wireless charging protocol for cell phones. Rumors had already been circulating that Apple (AAPL) was interested in partnering with them for wireless charging of iPhones.
Look at not just the price chart (the stock went from about $8.75 to over $30 in 2 days), but more importantly the volume chart – next to nobody was trading WATT on December 26, then suddenly tens of millions of investors flooded in on a single day. This sharp increase in volume, not just price, is what defines a “Mania”.
Crashes
A “Crash” inevitably follows – suddenly many of the investors think that the price MUST be near its peak and start to sell. The flood of new buyers also dries up as they look for the next shiny thing to buy, which means the economic forces suddenly flip. There are now too many sellers, not enough buyers, and the price starts to crash.
In the WATT example above, the stock’s price fell down to about $20 after a two-day mania. If you were a long-term trader in WATT who bought before the mania, you would still be turning a profit (although a much bigger profit if you were using a “Trailing Stop” order, which would have sold off when the peak started to end). But if you bought into WATT while the price was getting near the peak because you assumed it would keep going up, you would have just lost 1/3 of your investment.
Bubbles
The two examples below were a mania and crash of a single stock, but these same trends impact an entire industry, or even the entire market, as a whole. As the stock market itself starts to trend upwards, investors sell off other assets to “not miss out” on the bigger returns in stocks. When a mania hits the entire stock market, it is considered a “Bubble”.
You can see clear examples of bubbles by looking at charts. For example, here is the infamous “dot com” bubble of the early 2000’s:
Many investors in 1999 started seeing the huge returns that “dot com” stocks (e-commerce and new web-based technologies) were starting to produce, and money started shifting from other investments into these web technology companies. The bubble started to burst early in the year 2000; which many people argue was triggered by Pets.com, a company focused on selling pet supplies online. This company lost money on every sale. Its first year in business had about $670,000 in revenue, but spent over $11,000,000 in advertising.
When it started selling shares in the stock market, at first it was bought up like crazy by investors. However, major investment firms saw warning signs in their fundamental financial statements and business plans, and took out a public “short” position. This triggered not just a crash in the Pets.com stock, but investors started to take a closer look at all the other “dot com” companies that might have been over-valued. This caused a rapid sell-off and price crash.
Avoiding Manias, Bubbles, and Crashes
As a wise investor, your goal is never to buy a stock “just because it is going up,” but make your investing decisions based on longer-term trends and careful research of the underlying company. If you are interested in buying a stock that you suspect might be in a mania, spend a few days doing your research. Very likely the price will have already “Crashed” if there was no strong fundamentals!
In December 1999, at a holiday party for my work, I sat next to the husband of a colleague. As was typical of the day, the conversation quickly turned to investing in technology stocks. He said that Qualcomm (QCOM) was a great stock to buy NOW, despite the fact that it had already gained over 1,500% that year! He had no personal knowledge of Qualcomm’s business; its proprietary technology, the potential of the wireless phone market or any other fundamental reason to own the stock. All I could think of at this point was the scene in the movie “CaddyShack” when Rodney Dangerfield is playing golf and he gets a call from his stockbroker and he says, “I told you never to call me on the golf course! What’s that? Everyone is buying? Then sell. Sell. Sell!” I quickly sold my shares in QCOM for a sweet profit.