Modelling Boom & Bust in Stock Market for Smart Psychological Investing

By Abu Ahmed

Buying or selling of stock contrary to prevailing market sentiment market, in the flow of momentum, and around supports or resistance, intending to generate an alpha return is psychologically investing. The herd behavior investors exhibit in making investment decisions is a classic example of psychologically investing.

Individual traits continue to influence the individual in making an investment decision but are swept by the emotional wave flowing through the market.

Benjamin Graham, the great investor, acknowledged the importance of personality traits for smart investing in his book “The Intelligent Investor” by stating that “a trait more of the character than the brain.”

In search of such a model explaining the cause-effect relationship between the herd behavior and the swing in the market sentiment, I came across the concept of “Conglomerate Boom & Bust” presented by the same legend investor, the George Soros, in his book “The Crash of 2008 & what it means.”

He delimited the boom & busts cycle into seven delimited stages. He explained in detail how the herd behavior comes into play in the formation of each stage of the Conglomerate Boom & Bust Model right from its birth to demise. The model rests on two important assumptions i.e., prevailing bias and prevailing trend, besides host of other concepts such as the theory of reflexivity and fallibility.

Stage-1: The Inception of the trend:

The boom is in the embryonic stage and is beyond the notice of general investors. However, seasoned investors are not oblivious to the development that the acquisition of new business will trigger rapid growth in EPS in days to come. The prevailing bias forces them to accumulate shares gradually in the hope of price appreciation in tandem with the increase in EPS.

Stage-2: A period of Price Acceleration:

The gradual accumulation of shares ultimately sets in trend in price, which becomes prominent as the accumulation of shares gains momentum. The upward drive in price is reinforced by the renewed buying interest from Common investors. Prevailing bias and trends will continue to dominate the psychology of investors.

Stage-3: The Period of testing:

Then there comes a period of testing. Appreciation in price suffers a setback and shakes investors’ confidence in the validity of prevailing bias and trend. Fears of further fall in price put the investors in perplex w.r.t. continuing long positions. Likely outcomes of price setback could either be:

3a. that prevailing bias and trend survived and emerged strongest than ever and drives the price to a new high. The market will once again witness herd psychology but of much higher intensity. The greed drives investors to join the bandwagon under the influence of group thinking. The bubble sets in.

OR

3b. that prevailing bias & trend failed to survive. The exaggerated expectation of EPS growth will no longer sustain. Soros has termed this phase “A moment of truth.” The market will experience offloading of shares to some extent. This will be cooled off the market to a degree. This means no bubble is in ensue

Stage-4: A Twilight Period:

It is the aftermath when the share price recovers and surpasses the previous high. Around the new high, the stock starts appearing more than priced. Although investors no longer believe in prevailing biases & trends and at large uncertain of price break-out in a particular direction yet they continue to buy & sell shares at different price levels in expectation of making of quick profit by capturing volatility in prices. This drives the price into consolidation.

Stage-5: The Reversal or Climax

Consolidation in price with no longer belief of investors in prevailing biases & trends culminates into a downwardly break-out in price. This spells the initiation of bearish sentiment and investors start squaring off their long position with every downfall in prices.

Stage-6: Catastrophic downward Acceleration: At this stage deceleration in price accelerates and price nose dive sharply. The fall in price becomes steeper & steeper with the ever-increasing sell-off leading the market ultimately to crash under its weight. A perfect depiction of herd behavior once again. The process of conglomerate boom & bust may pictorially be depicted as under:

The whole process starts slowly, accelerates gradually, flattens out for an extended period, and then falls steeper than it has risen. To substantiate his theory George Soros presented price charts of LTV, ODGEN Corp, and TELEDYNE Inc. as circumstantial evidence.

This prompted me to examine the relevancy of the boom-bust theory to our market. Considering that there are very few companies that meet the criteria of conglomerate earnings, the basic presumption of conglomerate earnings for prevailing bias & trend has been substituted with normal earnings.

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ParameterGeorge Soros Boom and Bust Model

Amended Boom and Bust Model

1Prevailing BiasGrowth in Conglomerate EarningsGrowth in the earnings of a stand-alone company
2Prevailing TrendPrevailing trend is belief on the ability of companies to generate high earnings growth per share by using their stock to acquire other companies’ stocks selling at a lower multiple of earnings.Prevailing trend is belief on the ability of companies to generate high earnings growth per share by using their stock to acquire other companies’ stocks selling at a lower multiple of earnings.

 

Analysis of the price behavior of hosts of fundamentally strong and speculative stocks listed on the Pakistan Stock Exchange reveals the existence of a strong relationship between the boom & bust and psychological investing.

Traps in the model:

The testing period & the twilight zone are the traps within the boom & bust model. The former paranoids them with further fall in price beyond the level of initial setback whereas the latter trapped them in a hope of up-ward price break-out.

Framing up the boom & bust cycle for psychological investing:

Successful practicing of the model is required blending of Data Analytic, understanding of herd psychology and a good trading plan

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Key Skills

How it could be helpful?

1Data Analytic will help in:
  • Dependable prediction of the direction of price
  • Timely identification of emerging trend in stock price
  • Dependable prediction of the direction of price break-out during the twilight period
  • Facilitate in making informed decision w.r.t:
    • Accumulating additional shares OR
    • Divesting of existing holdings when there is setback in price or during twilight period.
2Knowledge about psychological traits influence investment decision making
  • Rationalizing of herd psychology w.r.t. investment
  • Make believe on the doctrine of psychological investing
  • Instill the needed courage to take stance on investing/divesting

When there is a setback in price or during twilight period

3A good trading plan will help in:
  • Optimal utilization of financial resources
  • Minimizing of investment risk &
  • Maximize likelihood of profit

 

There are theories in favor and against psychologically investing. Each one contains its framework for investing & trading in stocks. The cognizance of the fact that psychology is instrumental in smart investing does not offer a guaranteed return on investment. Practicing effectively not only requires the blending of knowledge about fundamental, technical, and herd investing and how they play roles in evolving boom & bust cycle but also demands the development of individual traits needed to complement the process actively.

 

The writer is a business graduate in Finance and MIS from IBA, Karachi with a MSc Statistics from University of Karachi and a fellowship in Life Insurance from LOMA, USA and a certified trainer by the US-AID Programme. He has has been associated with business schools as a visiting faculty teaching courses on investment, finance, and financial risk management. He is currently engaged in investment research and policy with one of the leading life insurance companies in Pakistan.