Bubble Psychology and Lessons from History

For starters, no market ever moves in only one direction. There are always counter-trend moves, some of which are very substantial. For instance, some of the largest short-term upward moves happened during the crash following on from 1929. In addition there were longer counter-trend moves which kept hope alive throughout a massive deleveraging:

We can expect to see such moves as well, and we can expect people to cast the most favourable light on every upswing, as if it was the dawn of a return to the previous ‘golden age’. Actually, extreme volatility is a sign of fear, and when fear is in control, markets are an exceptionally dangerous place to be. The potential to be whipsawed in both directions on a moment’s notice is very high, as is the risk that governments will rewrite the rules of the game, usually in a counter-productive way that will compound the pain.

The psychology of typical small-scale fluctuations plays out like this:

Click to enlarge

The psychology of a major bubble follows a similar pattern, but having risen to ridiculous levels of leverage, has very much further to fall. Much greater collective psychological extremes are experienced in a rare period of manic optimism, and its inevitable aftermath:

We are just past the point labeled ‘Return to Normal’, which corresponds to just after the end of the great sucker rally of 1930.

via The Automatic Earth: August 13 2010: Bubble Psychology and Lessons from History.

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