During the 2020-21 Covid-19 pandemic, the Nepal Stock Exchange (NEPSE) reached unprecedented highs despite the broader economic challenges. A speculative mania ensued in the market, driving the stock price of assets to all-time highs. The aftermath of the pandemic, compounded by weak domestic demand, the introduction of a margin lending cap and the Nepal Rastra Bank's benchmark interest rate hikes, made 2022 one of the most challenging years for the stock market. By mid-2022, investor sentiment hit rock bottom, weighed down by a persistently bleak economic outlook, leaving inexperienced investors with significant losses.

After two years of dismal performance, the pendulum has swung back as investors rallied around a more optimistic narrative: An accommodative monetary policy, perception of stable political alliance, availability of credit, and appointment of a market-friendly finance minister could stimulate growth, fueling economic recovery and market gains. NEPSE has experienced a remarkable 45 percent surge in less than two months since the CPN-UML and the Nepali Congress agreed to form the government in July.

Particularly noteworthy is the revival of familiar narratives and asset price speculation in the market, indicating renewed confidence among the market participants. A consistent pattern observed in every bull market cycle is that optimism overtakes rational judgment, and several shifts occur in the market, such as asset price increase, greed surpassing fear, the fear of missing out overriding the fear of losing money, and risk aversion and caution dissipation. With the sharp rise in asset prices since July, investors are again engaging in opportunistic buying with the anticipation of selling at an elevated price, speculating on the stock prices of various companies, and engaging in risky bets to harness profit and recover from the prior cycle losses.

This sentiment resonates profoundly with the cyclical nature of financial markets, where we witness recurring cycles that share striking similarities. As Mark Twain famously remarked, “History doesn't repeat itself, but it does rhyme.” These narratives follow well-known patterns that aren’t identical, particularly those related to human behaviour.

The market rhymes

The recent bullish sentiment in Nepal's financial market reflects the familiar patterns from the prior bull market cycles. Analysing market participants’ behaviour dominated by emotional biases provides an understanding of these market patterns. As co-founder of Oaktree Capital and investor Howard Marks indicated in his memo "Bull Market Rhymes," the stock market is heavily influenced by investor sentiments, leading to cycles of excessive optimism and pessimism. When optimistic narratives dominate, prices often spike far above the intrinsic value of assets, only to plummet when reality fails to meet expectations. This pattern persists, with prices oscillating between overvaluation and undervaluation, when market behaviour is primarily driven by emotional decision-making.

Financial euphoria is often attributable to the remarkably short-lived nature of market participants’ memory, leading to the swift forgetting of past market crashes. In recent weeks, investors haven't truly forgotten about the 2022 market losses; instead, they find themselves balancing the knowledge of prior cycle lessons and prudence against the greed of wealth. The desire to get rich and recover from past losses tips the scale in speculating asset prices and riding the tide. Prudence, caution and risk aversion are often sidelined in this pursuit. As a result, legitimate concerns are overlooked once asset prices gain momentum.

First movers gain a distinct advantage in the renewed resurgence in the market and often generate good fortune, owing more to luck than skill. The momentum attracts new investors to join the ride, and the self-reinforcing cycle intensifies, galvanising many more to join the market frenzy. The inflow of new capital from new entrants elevates the market prices even further, discarding investment principles and replacing them with new ones developed to rationalise the frenzy.

As historical cycles suggest, these influences inevitably subside, typically when optimism without fundamental support wanes. The past cycle suggests investors experience pressure when the new capital pool dries up. In due course, investors conclude that the rally drivers may not be as valuable as they perceived, and the fear of capital loss ensues, morphing into the terror of falling asset prices. Investors often forget that collective behaviours influence these market patterns and overestimate their ability to make the right decisions in the new cycle. While resisting the temptation of bull market psychology is not easy, holding on to a few principles may help market participants.

Principles to follow

Warren Buffett, the chairman and CEO of Berkshire Hathaway, emphasises the importance of extraordinary patience for investment success. As Amor Towles quotes in his book, A Gentleman in Moscow, “If patience wasn't so easily tested, then it would hardly be a virtue.” Resisting the temptation to act often exposes investors to the wrath of bubbles. The ability to watch paint dry usually helps investors see through the bubbles and avoid betting vast sums of money on the verge of excessive optimism.

The rare voice of reason is barely heard when the fear of missing out galvanises the market frenzy. Preparing to be lonely when most market participants believe the frenzy helps investors avoid the bubble traps. Some opportunities are lost, but it hardly exposes us to financial ruin.

Behavioural patterns have parallels in every cycle, and people who learn from historical cycles understand that the rally is not as mysterious as sizable market participants claim it to be. Even prudent investors may not detect the onset of the next bubble and predict turning points; those who learn from history recognise the rhythms of financial markets. These behavioural patterns are hard to identify and difficult to resist. Hopefully, some of these lessons will help us to avoid participating in the next bubble.