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Are We Entering Stage 3 Of The Bull Market?

  • Written by Syndicated Publisher No Comments Comments
    October 26, 2013

    Throughout human history the emotions of “fear” and “greed” have influenced market dynamics.  From soaring bull markets to crashing bear markets, tulip bubbles to the South Sea, railroads to technology; the emotions of greed, fear, panic, hope and despair have remained a constant driver of investor behavior.  The chart below shows the investor psychology cycle overlaid against the S&P 500.

    Investor-psychology-cycle-102313-2

    With the current bull market now stretching into its fifth year; it seems appropriate to review the three very distinct phases of historical bull market cycles.  While I am not suggesting that the current bull market cycle is set to end tomorrow; I am suggesting that we take a pause to question mainstream beliefs.

    Phase 1) “What bull market? The fall is right around the corner”

    Following a massive, mean reverting, correction – markets tend to bottom and begin an initial recovery. Most individuals have been crushed by the previous market decline and only recently “panicked sold” into cash.

    There are many signs during the initial phase that a new bullish uptrend has started.  Money flows from defensive names in order to chase higher yield, market breadth is improving, and volatility declines substantially.

    However, despite those indications, many individuals do not believe that the rally is real.  They use the rally to sell into cash and angrily leave the markets or continue to stay in cash expecting another failure.

    Note: The fastest price appreciation in the market happens during the first and third stages of the bull market.

    2) Acceptance stage 

    During the second phase individuals gradually warm up to the idea that the markets have indeed bottomed the psychology changes to one of acceptance.  At this point, the market is generally considered “innocent until proven guilty.“

    The overall psychology remains very cautionary during this second phase.  Investors react very negatively any short term market correction believing the bull market just ended.  They continue to remain underweight equities and overweight defensive positions and cash.

    During the second phase stocks continue to climb higher and market corrections are short-lived.  It is between second and third phases that a deeper market pullback occurs.  This pullback tests the resilience of the rally, shakes weak hands out of the market and allows for new bases to be formed.  This deeper pullback is used as a buying opportunity by institutions, which missed the initial stages of the rally, and their buying continues to push the markets to new highs.

    3) Everything will go up forever

    During the first phase, most individuals remain skeptical of a market that has just gone through a high-correlation, mean-reverting correction.  It is at this point that most investors are unwilling to see the positive change in market dynamics.

    In phase two, however, investors gradually turn bullish for the simple reason that prices have been steadily rising for some time. Analysts and strategists are also turning universally“bullish” in an attempt to manage their career risk and attract investor dollars.

    In the final phase of the bull market, market participants become ecstatic.  This euphoria is driven by continually rising prices but a belief that the markets have become a “no risk opportunity.”  Fundamental arguments are generally dismissed as “this time is different.”  The media chastises anyone who contradicts the bullish view, bad news is ignored, and everything seems easy. The future looks “rosy” and complacency takes over proper due diligence.  During the third phase there is a near complete rotation out of “safety” and into“risk.”  Previously cautious investors dump conservative advice, and holdings, for last year’s hot “hand”  and picks.

    The chart below shows these three phases of the bull market over the past three market cycles.

    3-phases-of-bullmarkets-102313

    It is necessary to remember what was being said during the third phase of the previous two bull market cycles.

    • Low inflation supports higher valuations
    • Valuation based on forward estimates shows stocks are cheap.
    • Low interest rates suggests that stocks can go higher.
    • Nothing can stop this market from going higher.
    • There is no risk of a recession on the horizon.
    • Markets always climb a wall of worry.
    • “This time is different than last time.”
    • This market is not anything like (name your previous correction year.)

    Well, you get the idea.

    Things That Make You Go Hmmm?

    Of course, just by looking at a price chart, it is difficult to state that we have definitively entered into the third phase of the bull market.  However, there are a couple of data points that go to support this premise.  If we reflect on investor psychology it is evident that individuals have generally done the opposite of what they should.  Individuals have, more often than not, bought into market peaks and sold market bottoms as the “emotional panic” to get in, or out, has taken control over logic.

    The chart below shows the flows of funds into and out of equity based mutual funds as tracked by ICI.

    ICI-NetEquity-Inflows-102313-2

    What is clearly evident is that investors, four years after the bull market started, are finally buying into the equity market.  This behavior has historically been associated with both short-term market peaks and major market tops.

    The magnitude of the rotation into equity based funds by retail investors suggests some caution about the current market environment.

    Secondly, margin debt and specifically net credit balances of brokers as reported by the NYSE should at least warrant some consideration.  When investors are extremely bullish, and pushing the edges of speculation, the “risk” of leveraging a portfolio is easily dismissed.  The chart below shows the positive and negative net credit balances relative to the peaks and troughs of the S&P 500.

    Margin-balance-vs-SP500-102313-2

    While these are only two data points; they suggest that the risk of a more meaningful reversion is rising.  However, it is necessary to note that “reversions” do not occur without a catalyst.  What will that catalyst be?  I have no idea and nor does anyone else.  Things that we are already aware of, like the upcoming debt ceiling debate, are already factored into the market.

    It is unknown, unexpected and unanticipated events that strike the crucial blow that begins the market rout.  Unfortunately, due to the increased impact of high frequency and program trading, reversions are likely to occur faster than most can adequately respond to.  This is the danger that exists today.

    Are we in the third phase of a bull market?  Most who read this article will immediately say“no.”  However, those were the utterances made at the peak of every previous bull market cycle.  The reality is that, as investors, we should consider the possibility, evaluate the risk and manage accordingly.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live

    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.

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