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

Four stages of a bull market and how to profit

More money is likely made from bull markets than any other market condition. Understanding how to invest during these periods is key to long-term success. First, a simple definition: A bull market is a congestive market composed of an extended period of time in which the stock indexes continue to register higher highs. It is composed of four periods. Two of those four periods are relatively easy to identify, while the first and fourth periods are a blending of the bull and bear cycles and are more difficult to spot.

These periods are often difficult to define clearly because they are normally rife with conflict. The cycles never change from black to white or white to black, but rather evolve in stages of gray. One of the skills of reading the market is to be able to interpret this gray as it develops and to identify the actual reversal points before they become clear to the general public.

Although they often look orderly in retrospect, bull markets are less clear as they unfold. They take two steps forward and one step back. Bull markets normally stagger around with little discernible direction. During the bull cycle, 90% of all stocks will slowly follow the 100-day moving average north. The problem is that they tend to check out every side road and rest area in the process. Although bull cycles occasionally develop strong trends, they are normally identified by continuation patterns.

Scaling outward helps. Just like a bear market, these markets can be confirmed by observing an 18-month simple moving average (see "Riding the bear," Futures, June 2009). This occurred in the present cycle in October.

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Period one

The first period of a bull market is marked by little, if any, public confidence and quiet accumulation by professionals. It is nearly impossible to identify this stage as it is happening. However, good fundamentals, improving earnings and bargain prices mark this as a period of accumulation by value buyers and institutions.

As this period develops, traditional reversal patterns in individual equities begin to appear. The average price is low and even the good stocks are cheap. Also, the price/earnings (P/E) ratios of the indexes are low. A few strong stocks now begin to break out of their sideways patterns. At the same time, isolated weekly and monthly highs occur as prices begin crossing their 100-day moving averages.

On balance, price action is dull and volume is low. While the violation of the 18-period moving average may have indicated a turning point in the overall market, it is not a guarantee that a particular stock will rebound soon. Many former market darlings will lie dormant for years.

Leading money managers now begin their accumulations based on the fundamentals. Because disillusionment with the market is the general temper of the public, good buying opportunities are abundant. Many companies with solid business strategies and strong competitive positions within their individual sectors offer real potential for price appreciation. Because most of those who found themselves in desperate need to sell have already done so, the supply is somewhat diminished. Therefore, to get strong stocks, traders now have to start giving higher prices to acquire them. Caution is still driving the bus.

Nevertheless, although values are good and the institutions are pursuing quiet accumulation, the public will not be back into stocks until they reach much higher prices. Most of the bottom pickers were slaughtered on the way down, and the reality is that there are only a limited number of players left.

Most people consider price as the determining factor that indicates the end of a bear market, but it really is time and fundamentals. For this reason, bottoms take much longer to form than it does for tops to collapse. Nowhere is this more apparent than in the opening stage of a bull market, and this is why it is hard to tell when you are in the first stage of a bull cycle and not in a bear market rally.

If you are looking for individual stock picks during this period, it is a good idea to watch for ones with good P/E ratios and return on equity values as they cross their 200-day moving averages.


Period two

In the second stage of a bull market, stock prices have been rising for several months and the mark-up is ready to commence in earnest. Market-leading equities are beginning to violate their 200-day moving averages. This is the time to buy the dips and ride the rallies higher.

Market newsletter writers and television pundits to the contrary, there is no magic in picking stocks in this period. In fact, you can pretty much select any stock and it will appreciate — the only question is by how much. If you are looking for individual stock picks during this period, it is a good idea to prospect the new highs found within the most-active lists.

Because money follows rallies, greed has been rekindled and more people are starting to think of the stock market as a wealth generator. Now there is competition by the public for a reduced supply, and accumulation is forcing prices higher. Some market participants are starting to show some impressive profits due to having bought early and simply holding. However, the larger public does not join the party just yet. Keep in mind that bull cycles take time to develop.

Market leaders are now rising to the top and the media loves them. Mutual fund inflows are increasing once it is apparent that the market is recovering. The Dow Jones Transportation Index now clearly reverses. It all comes down to markets being driven by liquidity and nothing else. Rallies are not caused by inflows, but rather inflows are the result of rallies — and rallies are the result of a series of higher highs. All of this is another way of spelling "greed."

Remember that it is not public demand that causes rising prices but the rising prices that cause public demand. The conclusion of this period is often marked by a significant retracement as the market pauses to catch its breath. However, too much greed is present for prices not to continue rising. As this retracement occurs, it is time to remember that bases must be built for the bull cycle to continue. Things are now getting in line for the third stage. Greed is driving the bus.

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