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Bubbles & Panic

As long as there are markets, there are bubbles. Two of the earliest bubbles to be chronicled occurred within the 1600s in Europe. One was the boom in prices of tulip bulbs in Holland that began in 1634. A single Tulip bulb sold for more than 5000 guilders (more than $ 60000) at the peak of the market.

see Thompson, Earl (2007)

The period after the second world war was a long period of stability for the United States, and while there was a stock market crisis in the 1970s, the bubbles in asset prices tended to be tractable relative to past crashes. In emerging markets bubbles continued to form and burst. In the late 1970s, speculation did create a temporary boom and bust in gold and silver prices. By the mid 1980s, there were investors who were willing to put away market bubbles to history. On October 19, 1987, the U.S. equities market lost more than 20% of their value in one day, the worst single day in market history, suggesting that investors, in spite of technological improvements and more liquidity, assigned a great deal with their peers in the 1600s. In the 1990s, we observed one of the latest market bubbles in the dramatic rise and fall of the dot-com sector. New technology companies with limited revenues and large operating losses went public. After peaking with a market value of $ 1.4 trillion in early 2000, this market get overwrought and lost almost all of this value in the subsequent two years.

Buying in a bubble creates a reflexive or self reinforcing feedback loop that economists called 'price to price feedback'. Selling after a bubble bursts has a emotional component. In the panic stage, asset prices reverse course and descend as rapidly as they had ascend.

Panic is an acute case of anxiety which dominates or replaces thinking and often affects groups of people. Panics typically occur in disaster or violent situations which may endanger the overall existence of the affected group. The word panic derives from the Greek πανικός, "pertaining to Pan", because the ancient Greeks credited the battle of Marathons victory to their goat-god, Pan. They used his name for the frenzied, frantic fear exhibited by the fleeing enemy soldiers. Humans are also vulnerable to panic and it is often considered infectious, in the sense one person's panic may easily spread to other people and soon the entire group acts irrationally.

In financial markets panic selling is a wide-scale selling, in order to get out of an investment. A rapid increase in sales order for a particular investment, which pushes down its price. This can cause a spiraling effect or "vicious cycle" in which investors see a rapidly decreasing price as a sign to get out of a investment, which further depresses the price and prompts more investors to sell. This type of selling is often related by a fear of loss. The main problem with panic selling is that investors are selling in reaction to pure emotion and fear. Almost every market crash is a result of panic selling.

Panic Selling. Eur/Usd 2010

Moreover "Loss aversion" (being more averse to losses than gains), as it is known in the world of behavioral finance, is validated within the VIX world. The VIX concept was first introduced by Prof. R.E Whaley at Duke University. With the introducing of the new VIX index in 2003, volatility has become an asset class. VIX futures and options are both negatively correlated with equity market performance.

The VIX is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis.

Investors believe that a high value of VIX translates into a greater degree of market uncertainty, while a low value of VIX is consistent with greater stability. Although the VIX is often called the "fear index", a high VIX is not necessarily bearish for stocks. Instead, the VIX is a measure of fear of volatility in either direction, including to the upside. A high value means that higher volatility is expected. Also, extremely high readings usually indicate stock market bottoms and extremely low readings usually indicate stock market tops.

The VIX directly refers only to stock and equities. Higher readings in the VIX, derived from prices paid for Standard & Poor's 500 Index options, indicate traders expect larger share-price swings in the next 30 days, so one can consider VIX as very useful indicative tool of market expectations. In cases of very high implied volatility one can even expect big collapses of stock prices. For speculation volatility is the best period of profits. Talking about VIX investors tend to believe that high value of it translates to higher risks in the market and lower value to more calm and stable markets.

Panic selling naturally creates great buying opportunities for well informed traders and investors. Those who know when the selling is over can benefit from the retracement that often occur afterwards.

Eventually, fear arises in investors as they start to think that the market is not as strong as they initially assumed. Inevitably, the market collapses on itself as that fear turns to panic selling, creating a vicious spiral that brings the market to a point lower than it was before the panic selling started, and from which it will likely take years to recover. The crowd is never wrong, reflexivity in financial markets or sell in may and go away ?

Extract

Ludewig S. The safe haven trade. Seek Alpha. 2015 N.Y.