From the September 01, 2010 issue of Futures Magazine • Subscribe!

Four stages of a bull market and how to profit

Period three

During this period, stock prices advance at a phenomenal rate. Cocktail parties are full of people with "hot tips." Most of the market participants are looking for easy money and little attention is paid to the underlying fundamentals of the larger market.

P/E ratios begin to achieve ever-higher levels, but that is immaterial. New stock market experts look upon all traditional fundamentals with disdain. Historical experiences are scorned, and the mantra of the day is that "it is different this time." New books about how to make millions in the stock market are common and fundamentals really do not seem to matter to anyone anymore.

About now, an initial public offering (IPO) craze hits the market. During period three, a plethora of new companies are formed to satisfy a public’s insatiable appetite for stocks of all kinds. The reason behind this is simple: There is more money to invest than there are shares available to sell.

In addition, a merger-mania also develops and buy-outs run rampant through corporate finance. The availability of leverage funds makes this possible. In other words, many companies are enjoying bloated stock prices to aid in the facilitation of any acquisition that might arouse corporate interest. As long as companies can convince others that their stock prices are valid, acquisitions are easy. Public relations and spin are now driving the bus.

Many leading issues actually will reach their highs during this period. They will then reverse long before the overall market shows any inclination to do so. This always leads to the last stage of a bull market and distribution begins. The professionals start to distribute some of the shares that were acquired in period one.

Period four

The main factors that have been leading the market to period four — and the coming market collapse — have been uneducated speculating and unrestrained leverage, both of which were aided by easy credit. This is finally becoming apparent to even the most unsophisticated market participants. Period four is rife with conflict and confusion. Slogans such as "if you would have put $10,000 in the market 50 years ago and never sold, you’d be a multi-millionaire today" are now common.

The market develops a theme. These themes culminate into an obvious bubble as the market seizes upon the theme and then goes slightly mad with it. These bubbles float on a sea of easy credit and greed and are rabidly pursued by the public as they dump ever more money into it.

We can go back over market history for hundreds of years and we will find bubble after bubble. There is one about every 20 years or so. These bubbles always are connected by corrective recessions or depressions but like the phoenix, a new bubble always springs forth from the ashes of the old as a new theme develops.

There has been the technology boom, where any company that had "tech" in its name was viewed as an instant path to riches. Then came the "nifty 50" where buying any of 50 blue chips stocks was considered a guaranteed path to wealth. The "conglomerate boom" was so volatile that it became the main concern of the academia that America was going to end up with only five to 10 public companies. Then came the "Internet boom" where all of the stores in America were going to close and people were going to buy everything, including their cat’s food, off of the Web. This incomplete list is to say nothing of the several real estate and commodity bubbles that connected them.

Normally, a bull market’s resolution is not the result of some cataclysmic occurrence or the result of a mature market, as the uninitiated tend to believe. It is the simple result of the inability to keep more and more money coming into the market. In other words, the market suffers from a shortage of players.

This is a period of high volume, high volatility and extreme vacillation. Profits achieved during period two and three have confirmed the belief of most investors that the bull market will continue forever. For these, the start of the upcoming decline is viewed as a gigantic buying opportunity. The truth is, those who see the lower prices as bargains are now the only ones sustaining the bull market. As prices continue to creep lower, the professional traders continue to sell into every rally. Clowns are driving the bus.

The market now begins to eat its own tail, effectively destroying any chance of the bull cycle continuing. We see many market-leading stocks react several points from their previous tops and then not retrace. Their race is obviously run. The best advice: When the press becomes euphorically bullish, but the cumulative advance/decline lines on the weekly chart of the indexes do not concur, tighten your stops, reduce your exposure and tread carefully.


The Tacoma Narrows

Anytime prices begin to print irrationally and your oscillators won’t behave, it is a head’s up to be careful. Extreme vacillation of price usually indicates that something is badly out of balance. Therefore, be wary of any market that seems unwilling to print decent charts. If a market won’t settle down and behave, the likelihood is that it is coming apart. Vacillation of the larger market indicates that something is seriously wrong. It is just that it is not widely apparent, at least not yet.

Whenever you see extreme vacillation in the larger market, it is a good time to remember the story of the Tacoma Narrows Bridge. In 1939, a bridge was built across the Columbia River at a place known as the Tacoma Narrows. Its purpose was to connect Portland, Ore., and Tacoma, Wash.

Unfortunately, the engineers never took the wind sheer of the river into consideration when they designed the bridge. After it was completed and in use, the wind forces created by the Columbia Gorge would whip the bridge up and down and side to side violently, eight to 20 feet at a time. In other words, the bridge was unstable. Although the bridge did not immediately fail, it should have been obvious to anybody who saw it that something was not right.

Nevertheless, it did not make much difference to the public. Despite the obvious weakness of the bridge, people continued to drive on it, walk across it and get their pictures taken while standing in the middle of it as it gyrated wildly above the river. They did this for over four months knowing full well that something was amiss. Fortunately, no one was killed in 1940, when the wind finally twisted the bridge badly enough that it broke up and fell 100 feet into the Columbia River.

As an interesting aside, starting with the year 1900, the length of the average bull cycle has been 40 months and three weeks, which is probably close enough for land mines and hand grenades. It should be noted that during a bull market, approximately 90% of all stocks follow the 100-day moving average higher.

Aubrae DeBuse has been engaged with the markets off and on since 1959 and is presently a proprietary trader for a family foundation.

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