Is the Market Bubble Bursting? (see chart).

BUBBLE-OMETER

For a talk earlier this week I reproduced our "Bubble-ometer" first profiled in Fall 2010 for the period from April 1998 through June 22, 2011.  It turns out that based on this simple metric of the number of mentions in financial social media of stock price action versus the number of mentions of company fundamentals (speculation versus thoughtful investing), we're likely in the midst of a speculative bubble.

PSYCHOLOGICAL PROFILE OF A MARKET TOP

To figure out a basic profile of market tops, we studied social media language predominant in the two weeks around seven recent market peaks: 

• Technology (QQQ) in early 2000,
• Homebuilders (XHB) in mid 2006,
• Financials (XLF) in mid 2007,
• S&P 500 (SPY) in late 2007,
• Energy (XLE) in mid 2008,
• Solar (TAN) in mid 2008, and
• Gold Miners (GDX) in April 2011.

SENTIMENT CHARACTERISITICS OF A MARKET TOP

• Sentiment is highly positive.
• Outlook (future-oriented) is positive and rising.
• Expressed Fear and discussed Dangers are low and declining.
• Expressed Joy and Positive Superlatives (“Best!”) are high.
• High frequency of discussions of positive earnings surprises.
• Discussions about the stock price are significantly more common than discussions about accounting fundamentals (a sign of “day-trading”).

WHAT TRIGGERS THE IMPLOSION OF A BUBBLE?
SIGNIFICANTLY:  Outlook (beliefs about the future) diverge from actual events (reality) at a peak.
In most cases, prices start to fall, but Outlook remains positive until surprising negative news collapses the Outlook vs. Reality disconnect.  Joy gives way to worry and doubt.

ARE WE AT THE PEAK OF A COLLAPSING SPECULATIVE BUBBLE?
Most importantly, did we see a market peak this April?  Suprisingly to me, the data suggest yes.
I'll keep working on the research, but the preliminary results indicate the next year is unlikely to be good for long-only investors.  Sign up here to keep abreast of our research via our free newsletter.

Richard L. Peterson, M.D.