Bubble Bursting

Forever in history, things get carried too far. We’ve seen it a couple times in the last ten years, first with the “dot-com” or “tech” bubble of the 1990s, and now the mortgage/mortgage-backed securities bubble resulting in the current recession. The current one hasn’t yet received an all-inclusive name. It will.

The Dutch had their tulip bubble where the price of a special tulip caused some to literally mortgage their house to purchase that tulip. The British had the South-Seas bubble where investment in anything relating to the exploration of the South Seas would be over-subscribed. It happened in the US in 1929 ending in the Great Depression of the 1930s.

Actually, it happens more often than one supposes. In the late 1970s-early 1980s, farmers greatly expanded production because of anticipated exports, borrowing much too much to accomplish that. When the anticipated markets failed to materialize, many farmers lost the farms that had been in their family for generations.

It also happened to the banks when they were falling all over themselves to loan money to Latin American countries, until in 1981 it became apparent that those countries weren’t repaying the loans except in cases where they were arranging an even larger loan. Most people never heard of that bubble and the banks silently worked it off their balance sheets from 1981 through 1989. Today’s FASB 157, the “Mark to Market” rule prevents banks from doing that, in part contributing to today’s banking meltdown.

We personally felt a bubble with oil going to $147 per barrel, driving gasoline to over $4 per gallon. That in part fueled commodities spirally upward to levels heretofore unseen. Then both bubbles burst for reasons as varied as those explaining the price appreciation. In a matter of months, prices were a mere fraction of their former peak.

The point is: Bubbles burst! Further: Bubbles always burst! When one hears the supposed wisdom, “It’s different this time,” it’s near the time that bubble will burst. The more supposedly the expert one hears speaking such stupidity, the more certain the outcome.

By keeping this in mind, one not only can make a living, one can become rich. It is not necessary to invest against the rising tide, but simply await the breaking of the bubble. In terms of the market, it only takes the most elementary of techniques to determine timing.

Let us take the pricing of oil as an example. It was indeed dramatic. I’ll use the graph of $WTIC, the representation of continuous contracts to track prices over a few years. The technique I shall use is the trendline. The pattern shown is the bump-and-run reversal.

First, trendlines: A trendline is simply a straight line drawn across price extremes. When a price is rising, the trendline is drawn across the dips in downward movement, and then extend it into the future. If one were invested in that stock, one would sell it when the price dips below the trendline. Were the price declining, the trendline would be drawn across the price peaks, and a buy signal would be indicated when the price broke above the trendline.

Second, the bump-and-run reversal pattern: A bump-and-run is created when the price bumps along the trendline, then moves well away from the ascending trendline. The reversal comes when the price returns and crosses the trendline. Once the trendline is broken, chances are the excursion away from the trendline before it is broken will be mirrored to the opposite side after it is broken.

In the case of oil, the bump-and-run occurred in two different time frames. The weekly chart showed it happening in a longer term, and the daily chart showed it was accelerating in the short term. Sounds like a double bubble, true bubble gum—and it was.

During the first week of July 2008, the daily trendline was broken and the target price was approximately 110, the trendline of the weekly graph. If that were broken, the next target area would near 70, one-half of the peak-price of $147. Finally, the longer-term graph shows a trendline at 70, which if broken would result in a target below 40. All were met.

To actually profit, one could use a new PowerShares ETN (Exchange Traded Note), DTO, representing the cost of crude. Previous ETFs were oil and gas companies, not crude oil itself. The initial position in DTO would have been at $29, and finally peaked over $250, in February 2009. Even had one exited the investment during the dip near year-end, one would have exited at over $100, or more than 300% in six months. Nice money, these bubbles.

To repeat the main point of this post: The world and markets are continually blowing bubbles. Bubbles burst. Bubbles always burst. If one refuses to get caught up in the mob psychology of the bubble, one can make astounding returns when bubbles burst.

PS: Bubbles form and burst at market bottoms, too. The Bump-and-Run Reversal Bottom has an average rise of 38%, a break even failure rate of 2%, and 68% rise to the highest point in the formation (meet target). Not bad.