The Shape of Market Bubbles

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Includes: DIA, EWJ, FCHI, QQQ
by: Doug Short

Note: This morning technical analyst and CNBC contributor Daryl Guppy made this prediction: Shanghai Index to Fall to 2,300 & 'Rapidly' Rebound. Click the title link to read his rationale.

Guppy's forecast prompted me to update the article below. In my view the bubble dynamics illustrated in the overlays are consistent with Guppy's analysis.


In my recent reviews of major worlds markets, I included a chart of the amazing bubble in the Shanghai Composite Index. In this post we'll build an overlay of four major bubbles across market history to see the variety of shapes a bubble can take. But first let's take a long view of the index. Incidentally, the index's latest close was 2586.21. So a fall to the area Guppy mentioned is about a 10% correction from this point.

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The next chart centers the Shanghai Composite. The peak is the center of a 3000-market day timeline. Markets are open approximately 250 days per year, so this is a snapshot of a little over eight-and-a-half years with plenty of room left to track the future behavior. The dramatic rise took place over about one year with a dramatic collapse of about the same duration. The symmetry of this these two years is astonishing and, as we'll see, not necessarily characteristic of bubbles.

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Now we'll add the Nasdaq Tech Bubble. The Nasdaq was a bit less aggressive in the early stages of bubble formation, but the collapses are remarkably similar.

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The next chart adds the Dow of the late Roaring Twenties and Crash of 1929. Here we see a more gradual bull market over the first five years with a major acceleration occurring in the 12-13 months prior to the peak. The 1929 Crash took the Dow to the legendary lows that the Nasdaq nearly equalled 70 years later. But the Dow decline lasted a good six months longer before beginning a sustained bear-market rally.

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The Nikkei 225 bubble is one I periodically feature in an overlay with the S&P 500, where it looks amazingly steep as the central pattern of a 40+ year timeframe. But in the context of this series, the Nikkei peak on the last market day of 1989 was far more gradual in both the making and unwinding. The first year of the decline, however, was as savage as the other three.

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Bubbles happen, and they usually go unrecognized by the majority of market participants until the late stages. The left side of the bubble is usually more gradual than the collapse, although the incredible rise of the Shanghai market is a notable exception.

People often use alphabet metaphors for recoveries: V-shaped, W-shaped and L-shaped. It's too soon to characterize the Shanghai Index, but the others most closely resemble an "L" over the timeframe of these charts.

Disclosure: No positions