How to make money on market bubbles

In the first half of the 17th century, Holland was gripped by “tulip mania”. By the beginning of 1637, tulip prices had risen an average of 25 times. One bulb was given as a dowry for a bride, three could buy a good house, and just one bulb of the Tulip Brasserie variety was given for a thriving brewery. But one day there was a crash, and prices fell by dozens or even hundreds of times.
Subsequently, a similar pattern was repeated many times in various segments of the financial markets. Each bubble was destined to first capture the public’s attention and then burst with a deafening crash, damaging many of those involved.

The classic bubble consists of four stages:

1. Зарождение. In this stage, the “smart money”, i.e. a limited number of the most advanced investors, enter the market.

2.Realization. The upward trend continues, the media begins to cover the story, and more investors join the movement.

3. Mania. Rising quotes and increased media attention create a feedback loop, moving prices ever higher.

4. Explosion. The price rise stops and pessimistic stories emerge. This leads to sell-offs. The bubble explodes. A new loop is formed when sell-offs reinforce sell-offs. The drop exceeds 50% of the supercrost wave, and can reach the levels of the beginning of the upswing.

Situations like this happen periodically around the world. Below will be a few tips on how to make market bubbles your friends.

• Try to invest in the nascent stages of a bubble before it is detected.

George Soros once said that when he sees a bubble forming, he starts buying, throwing wood into the furnace. An inquisitive mind can recognize the beginnings of a trend even before the news hits the front pages.

Take the Chinese stock market, for example. In August 2014, the Chinese government, faced with a slowdown in economic growth, cut rates on margin loans. State media began to describe the advantage of investing in equities. There were signs of a new mission of the Chinese government with a focus on stock market development. As a result, the Shanghai Composite index jumped 133% in 10 months (August 2014-June 2015).

A similar story happened with QE programs. In November 2008, the Fed initiated QE1, i.e. a large-scale purchase of mortgage-backed securities. The process of money printing started, which gradually evolved. As a result, a bullish trend in the US stock market started in March 2009, which has lasted for over 7 years.

• If you missed the nucleation phase, the awareness phase is also suitable for investment.

The main thing is to get ahead of “irrational optimism”. Note that QE1 in the US was followed by QE2 and QE3. Another example: QE1 of the Bank of Japan raised the Nikkei by 50%, and QE2 raised it by another 80%.

• Wait for “reverse bubbles.”

We are talking about strong, emotional and not fully justified drawdowns. Let’s recall the collapse in June on the day after the referendum on Britain’s exit from the EU. Then the world stock markets lost $2 trillion in capitalization. It turned out that the quotes were based on the worst-case scenario. In fact, there is a long negotiation process ahead. In addition, new monetary stimulus was soon unveiled. As a result, stock assets recovered quite quickly.

• Avoid the mania phase.

It is dangerous to both buy and short assets at such times. By mid-2015, the P/E ratios of Chinese stocks had soared to five-year highs. On the Shenzhen Stock Exchange, the forward P/Es of many technology stocks exceeded the extremely high level of 50 (the ratio of market capitalization to expected earnings). A snapshot of a Chinese fruit trader doing trading right at his workplace went around the internet. Not surprisingly, the collapse began in the summer of 2015. Now the Shanghai Composite is trading about 40% below its peak value.

To summarize, market bubbles are not always exclusively evil for market participants. A shrewd investor can even capitalize on such movements. As centuries of history show, the main thing is not to fall into euphoria, but to exercise restraint and patience.