Douglas Davenport: “To buy when others are despondently selling and sell when others are greedily buying requires the greatest fortitude and pays the greatest reward.” — Sir John Templeton
“Bull markets are born in pessimism, grow on skepticism, mature on optimism, and die of euphoria.” — Sir John Templeton
“The market can stay irrational longer than you can stay solvent.” —John Maynard Keynes
The bull market on Wall Street has now lasted for 50 months, close to the average length of the past nine similar periods. And the major U.S. stock indices have now surpassed their pre-Great Recession peaks. So is this bull market close to running out of steam? Is it time to take profits and sit safely on the sidelines?
Well, in order to answer those questions, it helps to have an understanding of cycles — specifically, the three stages of all bull markets and bear markets.
The Three Stages of Bull Markets
Phase One: Stealth
Bull markets start in Stealth. It is only with hindsight that we can recognize market bottoms. That’s when some intrepid souls start buying back in, against the advice of their friends and relatives. The list of reasons to stay on the sidelines or in short positions is long, and expounded with much authority by countless “experts.”
But the smart money buys when everyone else is bearish. These contrarians recognize that asset values have stopped falling, and begin accumulating. This lays the groundwork for the heady days of the bull market to come.
Phase Two: The Wall of Worry
During Phase Two of the bull market, most investors are still concerned that their small profits could disappear in a heartbeat. More of your friends, and the “experts” in the financial media, are coming around to your position. But the fundamentals are still uncertain, the gains seem tenuous, and the market may advance in stops and starts, not the headlong charge that most people associate with a typical bull market.
|Thanks to the Fed and other central banks, this is a bull market on steroids.|
Phase Three: Euphoria
Finally, the tipping point. The market has shown that it can bounce back from corrections, the fundamentals have turned undeniably positive, and even perma-bears are begrudgingly giving the rally its due.
You feel vindicated that your unpopular decision was the right one. Your friends are patting you on the back, and you feel justified in taking a bow. But now is not the time for congratulations. Now is the time you should be planning your exit strategy, because the mania is about to begin.
Now that everyone sees the light, and there’s no denying the bull market, the fools rush in. The last holdouts — the fence-sitters — see every minor pullback as their opportunity to get on board, and charge in heedlessly. Valuations climb well above historic norms, and logic and reason take a back seat to greed and delusion.
Prices make one last parabolic surge, known in technical analysis as a “buying climax,” producing the largest gains in the shortest period of time. Smart investors know that they can’t wait any longer, and they sell.
The Three Stages of Bear Markets
Phase One: Denial
The buying climax has produced the bull market high, although it is not recognized as such at the time. Little do they know it, but it’s all downhill from here.
Unfortunately, most investors are still in a bullish frame of mind. And why wouldn’t they be, when they’re sitting on solid profits in their brokerage accounts? Plus, they tell themselves, the fundamentals are still largely positive, and negative news is downplayed in the financial media.
They’ve seen the market bounce back from prior corrections, so they look upon every decline as another buying opportunity. Stocks are cheap.
This type of thinking often creates a bounce during this early phase of the bear market, but the rally has weak breadth and lower volume. The stock market tops out well below its previous high, and begins to sink again.
Phase Two: Concern
At this point, many investors become spooked. They begin to realize that the fundamentals have significantly worsened, and that this leg down is no blip on the radar screen; it’s a trend.
But for every investor who decides to sell, there’s another who hangs in, or even doubles down, feeling that the bottom is near. They reason that this may be the beginning of a new bull market, and they want to get in on the ground floor.
The market turns up, causing short sellers to cover their positions, pushing the market up even further. But this isn’t a turning point. It’s a Suckers’ Rally. It soon fizzles out, and the market turns south with a vengeance.
Phase Three: Capitulation
This new downturn convinces the majority of investors that it’s time to throw in the towel, if they haven’t done so already. Rational analysis gives way to fear of further declines, and the potential disappearance of remaining assets.
In human terms, this capitulation phase may be best categorized as despair. It is only when investors have reached this point that we can safely say the market is ready to make a bottom.
And now we have come full circle, because this is also the point when contrarians are once again ready to buck the bearish sentiment and buy back in, sparking the next bull market.
Which Phase Are We In?
When we recognize that all markets proceed in cycles, the obvious question becomes, “Where are we now?”
Well, it’s clear that we’re in a bull market, and have been for more than four years. But are we still climbing the Wall of Worry (Phase Two), or have we progressed into the Euphoria, or Mania, Phase (Phase Three)?
Based on my fundamental and technical analysis, I believe that not only are we in the final phase of the bull market, but in the late stages of it. Enthusiasm among investors has turned into delusion and greed. Even bears and fence-sitters are now throwing caution to the wind, and trying to ride an overcrowded bull.
So is it time for smart investors to pull back, and take their profits? Well, maybe not just yet.
Why do I say that?
It’s because I never forget the aphorism by John Maynard Keynes that has proven true time and time again: “The market can stay irrational longer than you can stay solvent.” In other words, the continuation of this bull market may not make sense, but that doesn’t mean that it can’t continue.
Yet another fact that you must keep in mind is that this rally is not entirely irrational. It’s being driven by hyper-active central banks such as the Federal Reserve and the Bank of Japan, which are printing a combined $160 billion per month.
If they continue to flood the markets with liquidity, and keep bond yields pegged at historic lows, that money will keep flowing into the stock market. Equities will become increasingly expensive, but there’s no reason the S&P 500 can’t surge to 1,750 or even beyond.
This bull market may be growing long in the tooth by historical standards, but thanks to the Fed and other central banks, this is not a typical bull market. It’s a bull on steroids, juiced up with easy money, and it’s likely to keep defying gravity for months, or even years.
Related: S&P 500 (INDEXSP:.INX), Dow Jones Industrial Average (INDEXDJX:.DJI).
Written By Douglas Davenport From Money And Markets
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