Is a Mini-Bubble Brewing?

BubblesThe markets are both fundamental and psychological. On the fundamental front, the economy is in horrible shape but the Fed may have printed enough money to avoid The Great Depression 2. However, on the psychological side I smell fear in the bear camp as markets keep moving higher.

Fear is an interesting emotion because it works both sides of the market. Obviously, on the downside fear leads to panic selling and oversold markets. However, on the upside, fear causes chasing by those who feel they are being left behind. I worry that if the markets continue to hold support and subsequently expand higher, a mini-frenzy may ensue to blow a mini-bubble.

The mechanics of such an event look like the following:

1) The market increases in value.

2) Money managers are forced to overrule their fundamental analysis and buy equities because managers are judged against the (rising) indices. This is commonly referred to as “performance anxiety.”

3) Individual investors are forced to overrule what they see economically in their community because they must make some money back (especially the Boomers and retirees) like the charlatans on TV claim they have been doing.

Therefore, you have two strong waves of future buyers slowly giving in to fear. Just like on the way down, as fear spreads the feedback loop simply feeds on itself to perpetuate rising markets.

Market psychology expert Denise Shull at Trader Psyches explains, “Brain and behavioral research, as well as our first-hand coaching experience, shows that the fear of ‘missing out’ is more compelling that the possibility of reward. In reality, this tendency drives all bubbles.”

Although the variables above have already been pushing the market higher, there are still a lot of burned investors missing the ride (a roughly 50% ride off the S&P 500 bottom, I might add). In the current market I have seen sentiments shift from hating stocks because they are down, to hating stocks because the move up was missed. On a weekly basis, I’m getting more fear-based emails and inquiries about whether it’s time to “jump in.”

If, and that’s a big if, the fear spreads to pandemic proportions, we could watch the markets go vertical as the great chase begins. Although I don’t recommend chasing stocks, I do recommend getting involved with tight stop-losses based on major areas of support. I this article, we show how our recent trade in Intuitive Surgical (ISRG) provided a winning framework no matter how “illogical” you believed the market to be.

If you don’t invest at least a little capital in the rally (with strong risk management protections and an ironclad framework), you risk joining the party at the worst possible time: after everyone else is already back in and no one remains to push your shares higher. That’s the moment of scary silence just before you hear the infamous sound, “Pop!”

This article was originally posted at Green Faucet on Aug 5, 2009.

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