The Stock Market Bubble

The greed and fear among the market participants are what make the stock markets volatile. Let us understand what causes stock market bubbles. The motive of this chapter is to understand the psychology of humans as to why they fear or greed and henceforth take advantage of the same and avoid herd mentality.

You might have observed that the government always tries to comfort the investors and favours booming markets. Booming markets bring in foreign investors (more forex reserves) and also establishes a good image of the government internationally.

Similarly, the regulator SEBI also wants the markets to boom as it is an indication of good corporate governance and an indication that it is doing its job correctly to protect investors' interests. Empirically it's been noticed that booming markets create more volumes in the market and, thereby, more revenue for the government. Similar is the case with the stock market, brokers, banks, AMCs, media, etc., who also love booming markets.

The other market participant which we all have heard about is the operator. Now, operators are the shrewdest of all these market participants. They know the psychology of the markets and hence exploit them to the fullest. The system works in this way – The company (promoter) unofficially appoints an operator. These are given some stock at the current market price and are also given a fixed amount in order to rig the market price of the stock. Now, the operator, who in most cases is the broker, investment banker, etc., influences the stock prices via Circular Trading. Let's understand this.

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Step 1: Create a band of brokers: The first step of rigging the price is creating volumes. The operators are a band of brokers who buy and sell amongst themselves with the motive of creating liquidity in the stock. Since the motive is to take the stock higher, they manage the high price by supporting any selling that comes into the market. All the selling is absorbed by the money received from the promoters and also operator’s own capital. At this stage, the brokers cannot exit. However, they are creating a reinforcing loop in order to seek the attention of market participants.

Step 2: Once the stock gets its feet and the fear of missing out (FOMO) is spread, the retail investors would themselves become the marketing agent of the stock. They would suggest it to their friends and family. Since the stock price is rising, by the heuristic bias, investors gauge that the company might be doing well. At this stage the stock is on an auto pilot mode and the operator’s role is to just keep up the image of the stock. They would pay the media agencies to telecast the stock’s price, give views on the stocks and also promote it to investor groups on telegram, twitter, etc. This bubble starts.

Step 3: Once the stock reaches a certain market cap threshold, the banks start trusting the company and issuing loans against it. This is where big traders and financial institutions enter the stock market, and the bubble is real. The operators can comfortably exit the stock because of liquidity and make good profits. The investors are now at the mercy of the stock price and the liquidity after this, which mostly ends in dismay as the insider information leaks, enquiry on the company is set up, and the regulator takes action on the company.

Now how to avoid this. Well, try to question every market move. In the bull run, question the source of money. In the case of a bear market, question the source of negative information. The purpose of this chapter was to make retail investors aware of how the market functions in real life. Stock prices are a reflection of a lot more than company fundamentals in the short term. Hence caution is warranted.

This chapter might have scared you a bit. However, in the next chapter, Parekh tells us why investing is important and why everyone in his/her own capacity must invest.