Wednesday, December 08, 2010

The MarketPsych Bubble-ometer: How To Know When There is a Market Bubble

I read a recent WSJ article on predicting bubbles.  Turns out there are many forecasting techniques from psychoanalysis to econometrics, but none is widely accepted.  I'd like to throw my hat in the ring here.

We've got our own technique for predicting bubbles, which naturally I think is the best :) 

As you may know, we're monitoring online conversations about stocks, and we're able to parse what people are talking about and their sentiment.

Here are our assumptions: 
1)  When investors (traders) are speculating, they are aiming for capital gains.  They want an appreciation in the value of the shares (or decline if they're a short-seller).  This focus on gains and losses is as true of "day-traders" as it is of "house-flippers."  Such speculators talk about stock prices and their likelihood of going up or down.
2)  When investors are investing, they are concerned with a business' viability, valuation, and its income - dividends, rents, cash flows, earnings, etc...  Investors talk about accounting issues and fundamentals.

Based on the dominant themes in online conversation (price speculation versus fundamentals-focus) we've created an index (the MarketPsych Bubble-ometer) to see which of these two groups is dominant in the markets.  An image of this index for the U.S. stock market is at the top.   It shows that based on this measure we are not currently in a speculative bubble for U.S. equities.

We've also got Bubble-ometers for individual market sectors and industries.  In a few weeks we'll post charts for the most and least-bubbly sectors and industries.  (Gold, anyone?)

If you avoid a market during a bubble, you can rest assured it will eventually fall below the current price. If you know a market is in a bubble, you may want to buy the momentum, betting on further inflation of prices (and your wallet).  It's a dangerous game, along the lines of the greater fool theory.

Happy Investing!

Richard Peterson
rpeterson - AT -

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