Impatient Bubbles

Where do Bubbles Come From?

Doing some thinking about various predictions I made in older posts along with predictions made by other bloggers, and it seems as if they are generally correct. Which got me to thinking if that isn't how bubbles begin - with widely predictable environments.

General macroeconomic developments are not that difficult to wrap your mind around and anticipate. Inflation isn't going to go from 2.7% to 0%, or to 5% overnight. It seems like bubbles really pick up steam when a majority of market participants correctly predict market events, and are not the result of wild "speculators" and other fools who placed incorrect bets.

The creation of bubbles seem (at least to me) to be the result of individuals following a very rational, typical line of reasoning. To the individual investor, you make a prediction about how the market is going to unfold over the next couple days, weeks, months, and even years. You then base your investment decisions based upon those predictions. Data is constantly coming in, and as data seems to corroborate your position, do you stick to your original allocation? Most likely not - you would act AGAIN based upon the same prediction. Even though your prediction is already priced into the market. Maybe you wouldn't act immediately, but as you see it is becoming a consistently winning sector or strategy, the impatience and urge to act again builds.
This is especially true if your prediction is initially luke-warm, but gains steam over the long run. You tend to pat yourself on the back by re-investing based upon your predictions. This process repeats itself numerous times, and across the market among many investors - as events unfold according to widely predicted events, investors are increasingly pursuing the same strategy, and upping their positions as data shows that they were right. And as the market is revealing its verdict that the prediction was correct, the predictions become more optimistic, even though nothing has fundamentally changed save other investors agreeing with your strategy.

The whole point of this is that the market has correctly been anticipating a slowdown for some time now, and as that scenario is slowly unfolding, several "congratulations" rallies have occurred. The market has congratulated itself for correctly (up to this point) predicting macroeconomic conditions, but can't seem to remember what the initial investment rationale was behind the positioning. Large Caps are the place to be in this slowing environment (who didn't see that one coming, the return of large-caps has been discussed for years now), but in a slowing environment should they be leading the market to all-time highs on a routine basis?

I think that impatience gets the best of investors in the formation of bubbles, and there is certainly plenty of that going around in this market. That is not to say that the current investment environment is frothy, but it seems to be inching closer.

Not so NYSE

Total Capitalization for the combined NYSE and Euronext has gone up 44% to 26.6 billion (as of this post). The breakdown for each stock is a 32% increase in Euronext Price, 56% increase in NYSE price since 5/31 closing prices (the day prior to the release of the merger details).

Euronext shares are getting hammered today, off 5.3% thus far on the news of Deutsche Bourse backing out of merger talks, however NYSE shares are up.

The point of all this is that NYSE stock is extremely overbought - I can't imagine that the merger with Euronext will make the company 44% more valuable (profitable) than they were as separate entities, and I think the new NYSE/Euronext stock is in for a bumpy ride as a result. Especially when you consider NYSE shares have outgained Euronext shares by more than 20%, and have not been affected to this point by the news that DB is no longer pursuing Euronext. Less competition means less bidding up of the stock, and NYSE shares would be expected to drop on this news.

The fact that NYSE shares have not been dragged down by the DB news and Euronext share plummeting isn't the only unique aspect of this merger. Typically the acquiring company doesn't outperform the target company's stock by 20%, especially considering each company will operate in a different regulatory environment. Combine this with some of the public statements by Mr. Thain guaranteeing the deal will go through (back when the NYSE share price was not that attractive and DB was still in play), and the NYSE appreciation smells a little funny. A lot of institutional investors have a vested interest in ensuring that the NYSE share price is attractive enough to see the deal through, and some of the one-day returns are abnormal to say the least. Seems as if the share price has become detached from the reality of the deal and any type of outlook on future profitability and is being driven more by the collective self-interest of NYSE shareholders. Almost every day after the NYSE price jumps significantly, it drops back on profit-taking. Can't say I blame them, I'd probably cash out at this point as well.