Major market cycles have a life of their own, like the ups and downs of a manic depressive patient. The choruses–sung at each stage from Excelsior on the way up to De profundis as the market falls through the floor–are not based on objective data; they are just rationalisations for what everyone is doing.
1. The Washout: “Stocks are Going Way Down”
At the bottom of a market crash, business news is usually terrible and many authorities declare that things will probably get worse. The public dumps stocks without regard to value.
Eventually, though, a point is reached where everybody who can be scared into selling has sold. Usually, the final battle occurs in a few days of extremely high volume known as a “selling climax.”
2. The Early Surge: “Things look better but it’s too early to buy. Wait for a pull-back.”
The government, shocked by the decline and, as always, beset by the clamour to “do something”, announces public works and other stimuli which, of course, will not take effect until many months later.
So, the pundits declare that, this time, the stimulus isn’t working. “It’s like pushing on a rope,” they say.
Months go by and prices rise. A few mutual funds will have been started during the bottom area: indeed, you read that the Hercules fund has risen 75 per cent in six months.
When “everybody” is waiting for a buying opportunity, there will ordinarily be no buying opportunity.
3. The Surge Continues: “Prices seem high. It’s too late to buy.”
More months pass and the market establishes an upward channel. Higher prices pull in buying from the institutions waiting on the sidelines. The public moves from feeling that it is too early to buy to suspecting it might be too late.
4. The Second Stage of the Rocket: “Maybe it’s okay to buy.”
A year or so after the bottom, the public, watching from the sidelines, becomes interested. There are a number of downward bounces, or tests, against the bottom of the market’s rising channel. Each time, the recovery starts from a higher level.
5. Not a Cloud in the Sky: “Buy!”
More months go by, the market is way up and the public is hooked. Business news is excellent. The “standard forecast” is optimistic. Jazzy new funds proliferate. Some particular market area becomes a market darling, if not a mania, and is bid up to irrational levels. We see, also, the latest leveraging toy—this time, the use of derivatives—on a vast scale.
6. The Blow-off: “Stocks can only go up.”
Hot Managers become famous. They chase new themes as a pack. It then becomes profitable to jump aboard a trend (in the early 1970s, each hot growth stock; in the early 1990s, the latest emerging country) instantly before the less-hot managers get hold of it and run it up.
7. Coasting: “The market does seem high but this time it’s different.”
As the months wear on, stocks hesitate; their upward pace slows, with only a few favourites making new highs. The market analyst detects this by the falling ratio of advances to declines.
Business starts to peak, but enthusiasts rationalise that the government has mastered the business cycle; or that there is an absolute shortage of stocks; or that emerging markets are a new world; or that hedge funds can make 20 per cent a year in any market.
In a bull market, though, enough stock is “manufactured” to satisfy everyone. “When the ducks quack, feed ‘em.”
8. The Top: “Hold!”
The government, concerned about speculation and economic overheating, starts leaning against the wind. The Federal Reserve raises the discount rate a notch.
Another few months pass and we see a series of vicious reactions, or chops. The arrival of belated “second chance” buyers halts each decline and puts the list up to new highs.
9. Over the Hump: “It’s too soon to sell.”
The public remains heavily in the market but the professional investors are edging out. A downward channel is established.
10. The Slide: “Prices are cheap but it’s too late to sell.”
After a few more months, a number of issues have fallen appreciably from their highs, perhaps 15 per cent. The market, like a tired horse that no longer feels the whip, sinks on bad news but fails to respond to governmental stimulation measures and bullish company announcements.
11. “It’s okay to sell.”
After a while, we may see a severe decline, with perhaps 25 per cent marked off the prices of the more volatile issues. There is often a deceptive recovery, which one might call the “trap rally”.
12. The Cascade: “Sell!”
Now the river seeps over the brink, carrying everything with it. A cardinal point of market strategy, if one is a trader, is to get out before this cascade, even if you have lost 15 or 20 per cent already.
Business news is bad and the standard forecast is for stormy weather. The hot-fund managers have to meet redemptions but find out that illiquid securities cannot be sold and depart in disgrace.
13 (or back to 1 again). The Selling Climax: “The market’s going way down.”
The torrent crashes down the hills. Some stocks give up in a day their gains for a years, and drop 50 per cent in a week. It is so sudden and so awful that, for a while, many investors cannot quite believe it.
So here we are again, four years or so after we started out, half drowned, bones broken, washed out. But if you have kept some reserves intact and know enough to recognize real value when it is being dumped by panicky, uninformed sellers, and have the guts to act, then you can make the buys of a lifetime at these moments.
We have had eight economic storms since the second world war. Each time, investors became convinced that the skies would never clear or the sun shine again. But it always does. ■
This piece originally appeared in the November 13, 1994 Financial Times. It forms the basis of a chapter in The Craft of Investing.