This essay was posted first in October 2003. I have archived it under My Essential Essays because, while it describes the bull market I experienced in the 1980s, it is the prototype for all bull markets:
I got an e-message from a friend a few days ago and he referred to the current rally as “the bull market.” It is no such thing. A bull market is a psychological phenomenon that has a series of distinct phases during which stocks move from under valuation to overvaluation. An astute investor can make and keep a fortune by making the proper moves through the course of these phases. The current rally is not one of these phases, and anyone who invests in stocks now will be contending with a set of conditions that will
make it near impossible to avoid getting wiped out. Following is a description of the bull/bear cycle:
A bull market has three psychological phases: Accumulation, Markup and Distribution. All three phases are required to produce wealth in a reasonable time frame.
Accumulation is the first phase. It cannot take place until the liquidation phase of the prior bear market is substantially complete. During Accumulation the psychology is at negative extremes because the excesses of the previous bull market resulted in great losses by investors and considerable pain in the economy. Valuations are extremely low because what was bought at a great premium did not work out and has since been liquidated at distress prices.. For
example, the price/earnings ratio on the S&P 500 today is around 29. During the first part of the 1980s it languished below 10, and got as low as 7 because investors wanted no part of the stock market.
The bull market that ended in 2001 had its Accumulation phase from the late 1970s to about 1985. I had spent the previous decade trying to cope with the awful bear market and, despite being a subscriber to both Russell and Prechter, I had a lot of trouble doing what they were recommending, which was to buy and hold. Most of my clients were just as skittish, preferring to buy short-term
bonds or utility stocks.
One of my clients was experienced enough to ignore the negative environment. Most of his holdings, to be sure, were tax-free bonds and utility stocks. But, in 1984 I showed him the promising research on a drug stock called Squibb and he bought 300 shares at about 34—a $10,000 investment. A year later, I suggested he review the outlook for the foreign markets, which led him to put $25,000 into a mutual fund that had a portion of its assets invested overseas. Stocks
were an extraordinarily tough sell in those days. This man, a retired dairyman from Okeechobee, was one of the few who could muster the right frame of mind. I’ll come back to him a little later.
After the selling subsides, the market begins the Markup phase. Gradually, the negative emotions in the market give way to a more positive outlook, but fear is never far away. The Markup phase of this bull lasted from about 1985 to late 1993. There were shakeouts along the way, but stocks moved up steadily on balance. However, any time there was a little scare, most investors ran for the exits. I had managed to position Squibb in a number of accounts and, after
some time, the stock began to move up with the market. By the time the stock got to 50, everyone except for the dairyman from Okeechobee was out of it, delighted to have made 30, 40 or 50% profits after so many years of losses. The classic behavior during a Markup stage is to take small profits because the dominant emotion is still fear.
The Distribution stage is when the public finally is convinced that stocks are the place to be. They have seen that setbacks were actually buying opportunities, so “Buy the dips!” becomes the mantra of the moment. It is a fine irony that this period is called Distribution, which implies selling, when so much buying is taking place and prices are moving up so rapidly. In fact, lots of selling is taking place, too.
Great fortunes are realized during the Distribution phase. Insiders, who sell their stock at hugely inflated prices to the public via IPOs make fortunes. Investment bankers, who package these offerings, taking large fees in compensation, make fortunes. These are the distributors in the Distribution phase.
There are other distributors. Investors who bought when no one else would buy and held when others were quick to sell have the correct frame of mind to sell when the most investors are clamoring to buy. The dairyman from Okeechobee “distributed” his Squibb in 1996. It was now 1,200 shares of Bristol Myers-Squibb and it went to the crowd at 91 a share, turning $10,000 into $109,000. In 1997 he “distributed” his $25,000 position in the mutual fund for $287,000. Thus, a $35,000 investment became $396,000 in little over a decade!
But, wait. Not just any decade. It was a decade that included the Accumulation phase, were he could buy stocks at great discounts; the Markup phase, during which his investments could develop a track record of performance, and, finally, the Distribution phase, when the crowd could express their fervor for that performance by paying him a rich premium to take the stock off his hands.
Insiders and investment bankers can make fortunes anytime the public is salivating for stock. But individual investors need a complete bull market and the proper tactics to make and keep a fortune.
So, what about investors that finally got excited about stocks in the late 90s?
These are the “distributees”, otherwise known as bag holders. Their fate is to get wiped out in the bear market that follows:
Bear markets have two phases: Markdown and Liquidation.
I have cited studies in other essays that show that few if any investors who were putting money in the market from 1995 to the present have as much in their investment accounts as their cash contributions. From 1995 to 2001 the market soared. Most investors were heavily involved in NASDAQ stocks and the NASDAQ went from 1,500 to 5,000. It has since collapsed. I’ve also cited the mutual fund statistics that show that virtually no liquidation has taken place. Less than 2% of stock mutual fund accounts that were active in 2001 have been closed (see vol. 10). From March 2001 to October 2002 the speculative sectors underwent a Markdown.
During a Markdown, stocks fall sharply without any significant amount of selling by the public. The chart of Cisco Systems for that period resembles the trajectory of a cat flung from a forty-story building. The stock of the poster child of the “New Economy” fell from 84 to 7 in eighteen months. It has since rallied to the low 20s. “You get one rally”, said the venerable market watcher Robert Farrell, “then they drift off into oblivion.” He was talking about the
oil service stocks after the brief oil mania of the late 70s. The few surviving companies among the group didn’t make new highs for 15 years.
When a group of stocks undergo a mania-like run up and then collapse, short covering and speculative buying cause them to bounce in an echo rally known to professionals as a Dead Cat Bounce. The techs have been in this bounce for a year. The rally has been technically weak, and it has recently been outright frightening. During the run up of the NASDAQ from 1999 to its peak in
2001, margin debt climbed from $10 Billion to over $20 Billion, causing the chairman of the SEC to warn investors of the dangers of buying on margin. Shortly after, the market went south in a big way and margin debt fell back below $10 Billion. This time it didn’t take a year. In the last two months margin debt has screamed up to over $25 Billion, more than at the peak! Meanwhile, Investors Intelligence reports that insider selling is more persistent and more urgent in more companies that at any time since they have been keeping
records. The cat is dead. It bounced, but it’s still dead.
All that is left in this bear market is the Liquidation phase. Despite ever worsening business fundamentals with record job losses and plant closings, unprecedented migration of jobs to China, India and the Ukraine, record personal bankruptcies, record debt throughout the global economy, severe shortfalls in tax receipts at state and local governments and a ballooning federal budget deficit, investors hang in by suspending disbelief. All of this has happened before and it always leads to Liquidation, the phase in which investors try in vain to be the first one out the door. Another word for Liquidation
is bloodbath. It is coming soon.
Update, August 2011: In the period after 2003, the market underwnet a vigorous bear market rally, which ended in 2007. The Liquidation phase of this cycle is still to come and, given the degree of trend, it will be very severe.
The author makes no representation as to the accuracy of the quoted material, but believes the sources to be reliable. No one should consider any part of this presentation as a recommendation to buy or sell any securities whatsoever.