The biggest learning that the marketplace imparts is about human emotions.
Yeah, Mrs. Market brings you face to face with fear, greed, exuberance, courage, strength, arrogance … you name it.
You can actually see an emotion developing, real-time.
Today, I’d like to talk about the chronology of exuberance.
In the marketplace, I’ve come face to face with exuberance, and I’ve seen it developing from scratch.
When markets go up, eventually, fear turns into exuberance, which, in turn, drives the markets even higher.
What is the root of this emotion?
The ball game of exuberance starts to roll when analysts come out with a straight face and recommend stocks where the valuations have already crossed conservative long-term entry levels. As far as the analysts are concerned, they are just doing their job. They are paid to recommend stocks, round the year. When overall valuations are high, they still have to churn out stock recommendations. Thus, analysts start recommending stocks that are over-valued.
Now comes the warp.
At some stage, the non-discerning public starts to treat these recommendations as unfailing cash-generating opportunities. Greed makes the public forget about safety. People want a piece of the pie. With such thoughts, the public jumps into the market, driving it higher.
For a while, things go good. People make money. Anil, who hadn’t even heard of stocks before, is suddenly raking in a quick 50Gs on a stock recommendation made by his tobacco-seller. Veena raked in a cool 1L by buying the hottest stock being discussed in her kitty party. Things are rolling. Nothing can go wrong, just yet.
Thousands of Anils and Veenas make another 5 to 6 rocking buys and sells each. With every subsequent buy, their capacity increases more and more. Finally, they make a big and exuberant leap of faith.
There is almost always a catalyst in the markets at such a time, when thousands make a big and exuberant leap of faith into the markets, like a really hot IPO or something (remember the Reliance Power IPO?).
Yeah, people go in big. The general consensus at such a time is that equity is an evergreen cash-cow. A long bull run can do this to one’s thinking. One’s thinking can become warped, and one ceases to see one’s limits. One starts to feel that the party will always go on.
Now comes the balloon-deflating pin-prick in the form of some bad news. It can be a scandal, or a series of bad results, or some political swing, or what have you. A deflating market can collapse very fast, so fast, that 99%+ players don’t have time to react. These players then rely on (hopeful) exuberance, which reassures them that nothing can go wrong, and that things will soon be back to normal, and that their earnings spree has just taken a breather. Everything deserves a breather, they argue, and stay invested, instead of cutting their currently small losses, which are soon going to become big losses, very, very big losses.
The markets don’t come back, for a long, long time.
Slowly, exuberance starts dying, and is replaced by fear.
Fear is at its height at the bottom of the markets, where maximum number of participants cash out, taking very large hits.
Exuberance is now officially dead, for a very long time, till, one day, there’s a brand new set of market participants who’ve never seen the whole cycle before, supported by existing participants who’ve not learnt their lessons from a past market-cycle. With this calibre of participation, markets become ripe for the re-entry of exuberance.
Wiser participants, however, are alert, and are able to recognize old wine packaged in a new bottle. They start reacting as per their designated strategies for exactly this kind of scenario. The best strategy is to trade the markets up, as far as they go. Then, you can always trade them down. Who’s stopping you? Shorting them without any signals of weakness is wrong, though. Just an opinion; you decide what’s wrong or right for you. The thing with exuberance is, that it can exercise itself for a while, a very long while – longer than you can stay solvent, if you have decided to short the markets in a big way without seeing signs of weakness.
At market peaks, i.e at over-exuberant levels, long-term portfolios can be reviewed, and junk can be discarded. What is junk? That, which at prevailing market price is totally, totally overvalued – that is junk.
Formulate your own strategy to deal with exuberance.
First learn to recognize it.
Then learn to deal with it.
For success as a trader, and also as an investor, you will not be able to circumvent dealing with exuberance.
Best of luck!