WHERE ARE WE IN THE BUBBLE PROCESS?

Secular bear markets have a way of fooling investors at every twist and turn.  Just when you think recovery is around the corner everything seems to change on a dime and the bear sinks its claws back in.  But what rarely changes throughout time is psychology in regards to bubbles.  We’ve discussed the dynamics of bubbles in past articles and this instance is unlikely to be all that different.

Time after time we see the same sentiment and the same fundamental mechanics at work.  In each case, we see massive supply/demand imbalances.  The supply build leading up to the bubble persists for years and sometimes decades as irrationality grips markets.  Demand rips higher until it outpaces supply.  The market begins to falter.  As demand subsides the bubble shrinks.  At first, investors aren’t convinced prices will fall substantially and buyers come in. Ultimately, the laws of supply and demand impose their will on the market and the shrinking demand can’t meet supply.  Prices continue to fall until capitulation sets in.  Its not until that point that investors finally fold and prices tank.  Only then can the markets normalize and the healing process begin.  Unfortunately, due to the continuing supply imbalances this process generally takes years if not decades.  What we’re experiencing now in many markets is unlikely to end differently.

After watching one of the greatest credit bubbles of all time investors are wondering where we are in the cycle.  Is this a head fake or is this really the bottom?  The following chart shows the stages of a bubble and the sentiment changes that accompany the various stages.  What investors need to ask themselves now is whether we are at the “return to normal” stage (before another massive collapse) or at the “return to the median” stage (before some form of recovery can begin).

In my opinion, I think the panic phase of the credit bubble is past us.  Unfortunately, what is consistent in each of the major bubbles in the history of the world is that they always suffer extended periods of sideways to down action (though generally not dramatically down).  The playbook is disturbingly consistent in prior bubbles.  While government officials believe they can fend off the laws of supply and demand with stimulus history proves otherwise.  In all likelihood, continued government spending and intervention will only prolong the inevitable.

We have previously discussed the dynamics of the housing market bubble among others.  Using the Nikkei, gold bubble, Great Depression and Nasdaq Bubble as reference its likely that the bubble markets of the last few years are in for a sustained and difficult road ahead: