One curious aspect of recessionary and/or bear market environments is that they have propensity to facilitate the formation of bubbles. On the face of it, this seems strange - why would people become more willing to speculate in obscure or unproven securities during times when money becomes tight? It definitely is a strange phenomenon, and yet it is one that has repeated itself time and time again.
Just recently, shares of car rental company Hertz (HTZ, Financial) soared on news that it was filing for bankruptcy as retail investors - many of whom were completely new to the market - poured into the stock. Elsewhere, a similar story formed around shares of beleaguered oil and natural gas provider Chesapeake Energy (CHK, Financial), whose share price spiked from $14 a share to almost $70, before collapsing back to $14, all in the space of a few days.
Clearly this is not normal. And it’s not just stocks - novice traders have flocked to triple-leveraged ETFs as well. So why do bubbles form during uncertain times? Let’s dig in.
The psychology of speculation
One theory as to why there has been a sudden flood of speculative trading in the last few months is that new market participants who aren't in a financial crunch are using the stimulus checks deposited by the U.S. government into their bank accounts to gamble on the stock market. Quarantine boredom has been thrown around as another possible explanation.
However, while there is no doubt that these factors have contributed at least a little to the speculative activity we have seen develop recently, they don't explain why this has happened during previous crises. After all, people were speculating in triple-leveraged ETFs during the darkest days of 2009 too.
The answer is volatility. There is a saying that bull markets are an escalator and bear markets are an elevator. The way up is much more orderly and consistent than the way down. Recessionary and bear markets are almost always more volatile than bull markets, and with volatility comes the potential for quick gains (as well as quick losses).
People see headlines about day traders making 10 times their starting capital over the course of a single week by selling naked options and want to do the same thing. They don’t consider that those headlines focus on the happy winners and not the unlucky losers. It hasn’t helped that trading is as cheap as it has ever been, with many brokerages offering ‘free’ trades (so long as you don’t mind your order flow being sold to algorithmic traders). Volatile markets can bring out the speculative urge in even the most seasoned investor, so it is important in times like these to learn from the numerous examples of burst bubbles throughout financial history. You never know when you have hit the top, so don’t try to predict it.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Howard Marks: The Market Cannot Tell You the Future
- Jim Chanos: The Problem With the Gig Economy Business Model
- Carl Icahn: How Companies Use Buybacks to Increase Stock Price
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