Bubbles Burst

Bubbles

Today I examine market/financial bubbles.

Wikipedia's definition of an financial bubble:

"An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, or a speculative mania) is “trade in high volumes at prices that are considerably at variance with intrinsic values”

Bubbles vary in length and magnitude.

Market psychology on the way up:

- Excitement
- High expectations
- Hype
- Speculation
- Market sentiment (mood) often bullish.
- Sector sentiment often very bullish.

Mark psychology on the way down:

- Reality sets in
- Actions (of managers) speak louder then words
- Deadlines not met
- Cost overruns
- Market sentiment may be bearish.
- Sector sentiment may be very bearish.

My interpretation of bubbles:

i) A lot of bubbles start with a strong breakout of resistance, which then sets into a long up (bull) trend.
ii) The peak is usually brief - with little consolidation.
iii) Support is broken at the top and a strong down (bear) trend sets in which gains momentum.
iv) The bubble more often then not goes back to the pre-bubble resistance line (now support line).

Technical Analysis of sharemarket bubbles

The following is another perspective on the Australian All Ordinaries chart applying my interpretation of a bubble.

Chart 1: The All Ords bubble has burst back to the pre-boom levels.
The bull market lasted around 44 months, while its taken only around 13 months to deflate. This illustrates that as soon as the All Ords hit a technical bear market in January 2008, the sellers flooded the market and sold out of holdings at almost any price.

Shares which Bubble:

There are countless examples on the Australian stockmarket (and indeed any financial market) of bubbles which have burst back to pre-bubble levels. Each bubble is unique in magnitude and length.

To show this, lets have a look at Compass Resources (CMR.ax) and Minemakers (MAK.ax).

Some bubbles have an equal inflation and deflation, such as Compass Resources.

Last week Compass fell into administration. The company had potential to be a significant lead/zinc producer with operations in the Northern Territory. The company was one of the best performing stocks in 2006, its now in the worst performing stocks for 2009, having essentially reached zero shareholder value.

Chart 2: Compass Resources. Its bubble had a more equilateral rise and fall.

Other bubbles have rocket-like momentum on the way up, with a longer decline when the bubble pops.

Chart 3: Minemakers - phosphate bubble
Minemakers had an extremely volatile 2008. It went up an astonishing 700% in only three and a half months, then took 7 months to fall back to the 45 cent region. A big bubble inside the space of one year.


Commodities Bubbles:

The following charts show bubbles which have burst in some of the main commodities (both metals and food). Each chart is measured in $USD and is over a 25 year period. (these charts are sourced from IndexMundi

Chart 4: Copper

Chart 5: Zinc

Chart 6: Wheat

Is it a bubble? Depends on your measuring stick:

All the above charts, have been measured in terms of fiat currencies, that is, the Australian Dollar or the US Dollar.

Could it be that the extreme volatility in sharemarkets, property, commodities etc in recent years has been largely attributed to the world monetary system?

If you measure a tangible good vs another tangible good (say gold vs crude oil), price will always go sideways over time (from oversold to undersold and back again). In other words you have one finite resource vs another finite resource. Supply and demand determine price.

However measuring price with fiat currencies we have a situation where the money supply is expanding at an exponential rate (see my article on money supply >here<). We need more and more money to buy the same amount of gold or barrels of oil. This is inflation and the devaluation of currency. Since 1971, when President Nixon closed the Dollar link to gold, the US money supply (based on M3) has increased by over 1300 percent. A 13 fold increase in 37 years. This is the main cause of the big bubbles in recent years, and the subsequent deflationary pressures causing most to burst to pre-bubble levels. (The Australian Dollar has lost around the same amount of purchasing power since 1971).

To demonstrate the difference between fiat-based bubbles and measuring a tangible vs. tangible, lets look at Crude oil, first against the US Dollar, then crude oil vs gold.

Chart 7: Crude Oil in $USD terms - Nothing has fallen harder then oil in the last year.

Chart 8: Crude Oil in Gold terms (both using USD as Index). Also known as the gold-oil ratio.

Chart 9: Was there a bubble and crash in oil? Not when measured against gold.
If you compare this chart to the USD measured crude oil chart, the spike when oil went to $147 is shown by a small movt against gold. Indeed oil was outside the trend and expensive against gold. You only needed around 6 barrels of oil to buy 1 ounce of gold. Conversely, as oil crashed below $40 USD in late 2008 (and Gold recovered slightly in USD), oil in terms of gold moved back up its trading range, making gold look more expensive and now requires around 20 barrels of oil to buy one ounce of gold.

So where is the bubble and the crash?

* There is much less extreme volatility if you measure tangible goods vs other tangible goods *

Conclusions:

- Since 1999 there was a major change in the tide. We moved from a financial (debt) cycle to a commodities cycle (we are halfway through an average commodities cycle).
- This has caused extreme volatility and uncertainty in pricing of financial assets (sharemarket, property).
- Financial assets are now facing deflation. In other words, debts are being revalued and re-risked.
- Meanwhile tangibles (when priced against one another) continue to move between overvalued and undervalued. Very few bubbles are formed. Value will always go sideways over time under this measuring stick.
- Bubbles have been dramatic only in terms of fiat based currencies.
- Future financial bubbles will be even more volatilie and even more inflationary on the way up.
- Be weary of charts which go rise too quickly. A vertical movement must find a new level of support at the top.
- The peak point is the key. If it cannot hold the peak levels, expect a strong downward movement from the top.
- The Australian sharemarket bubble has broken, but this will not stop it from going lower.
- The next big financial bubble to burst is Australian housing.
- Government's and central banks will do whatever they can to keep "prices" artificially high rather then let financial debts burst.
- They will do this at the cost of the fiat based monetary system. (Hyperinflation bubbles should be seen by 2020).

Cheers
Scott