Sunday, 27 January 2013

If a Bull Market ends and no one is around to short it, does it make a top?

The objective of this post is to discuss the phenomena which usually accompany (and thus signal) the end of a bull market. These characteristics are generally present around the top of both secular and cyclical movements, although they obviously tend to be more evident in the former case than in the latter. 
It appears to us that currently one would be hard-pressed to find them in the Yen market, whilst they abound in the stock market. We suspect that a year from now the words of the immortal Jesse Lauriston Livermore could come in handy: “It didn't require a Sherlock Holmes to size up the situation.” 
The list we are presenting below isn’t complete: we have not included other factors which, although common, might fail to appear with such unwavering regularity, or others which we deem less important or less distinctive of a top.

The usual companions of a dying bull market

1. An already-deteriorating fundamental backdrop (often accompanied by an actual disregard for fundamentals)

This is by far the most important characteristic. It almost never fails to appear and it almost never fails to signal that the top is near. When the mania is underway, the public stubbornly refuses to listen to the various Cassandra foretelling doom on the basis of sound factual analysis and actual data: this explains why the highest prices in a bull market are always reached when the fundamental drivers which fuelled the move have already disappeared or at the very least have significantly deteriorated and are about to change direction.
Let’s take Apple as a recent example: as Reggie Middleton of BoomBustBlog has pointed out many times in his excellent Google vs. Apple analysis, when it traded at 700$ per share the company had already been outclassed by its competitors and was losing competitiveness and market share day after day, as well as starting to feel the pinch of margin compression. And yet you could hear nothing but bullish calls on it, everybody knew it was certainly going to go to 1000$ and everybody was invested. But in all fairness, we can’t blame the poor saps: “This time is different”, after all! 
In fact, it is not: failure to appropriately consider the fundamental landscape on the basis of the wrongly-held belief that some magical forces are at work which will undoubtedly cause prices to rise indefinitely always leads to financial disaster. It happened in 1929, when stocks supposedly reached “a permanently high plateau”; it happened in 2000, when conventional valuation methods were to be be discarded because internet companies were somehow held to be “different” (i.e. they could apparently survive without having to generate any profits or even revenues); it will happen again whenever a similar set of conditions will manifest itself. To again quote Livermore: “Another lesson I learned early is that there is nothing new in Wall Street. There can't be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.”

2. Widespread public participation

This is an easy point to make: if everybody is already in the market, who is actually going to come in and push prices even higher?! The moment one buys an asset, one becomes a bearish force in the market, since it’s logical that at that point one can only sell what it has previously bought (of course we’re omitting the possibility that one buys even more, something many chaps like to do at precisely the wrong time). 
It’s like an overcrowded boat where everybody leans to one side to watch a whale: by the time they’re all there, the whale is gone and the boat capsizes. Apple was (and probably still is) the most widely held stock amongst large mutual funds and hedge funds (and we suspect we could include the public as well). 
It’s never nice to be in room full of people when somebody yells “Fire!”, but this inevitably happens at the end of major bull runs, as herd behaviour, euphoria, greed and the fear of missing out push the unsuspecting public in the trap.

3. A blow-off top / Euphoric rally

The last consideration we have just made above serves us well in explaining this next point: when everybody (including previous disbelievers) finally becomes bullish and jumps on the proverbial bandwagon, a powerful (oftentimes almost parabolic) rally ensues, which culminates in a so-called blow-off top, after which prices generally collapse right away. Sometimes, as a new wave of fools, enticed by the “bargain”, rushes in, prices sharply recover and even make marginal new highs: this tends to happen more frequently in the stock market (as an example see the S&P500 between July and October 2007) than in other markets (like e.g. commodities). 
Of course the quasi-vertical rate of ascent witnessed during these runs is unsustainable and a big hint that it’s time to get out, but to the excited public it means nothing but the guarantee of even higher prices to come. During the last year of its uptrend, Apple saw its price almost double: quite an impressive feat for a stock with such a large capitalization. But after all it was meant to go to 1000$…

4. Overly bullish and complacent sentiment

Daring to call a top of a bubble near its actual peak can prove detrimental to one’s health: people, excited by their own delusions, angrily and rabidly turn against all those who try to spoil their dreams of boundless wealth. Rational investors suddenly become “losers”, “haters”, “failures” and all reasoned arguments forwarded by them become irrelevant, since “this time is different” etc. Intoxicated by the artificial abundance of paper money and bank credit, the wonderfully irrational animal that man is happily engages in all sorts of unsustainable bubble activities, convinced that “no harm will befall you, no disaster will come near your tent” and that the Land of Cockaigne is just around the corner: all is needed is for the party to last a bit longer and not surprisingly party poopers are not welcome. 
Of course, this is nothing but a bitter illusion and the ensuing reality is even bitter. As Mises so aptly put it: “The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.”  
These considerations and Mises’s wise words apply to speculative excesses in financial markets as well: conventional wisdom postulates that when something has been going up for quite some time, then it logically follows that it can only continue to go up and those who refuse to acknowledge it have simply missed the boat…The reality is that whenever excessive bullishness, complacency, overconfidence and sheer euphoria abound, then it’s time to quietly take the other side of the public’s bet. And the unchanging human nature (helped along by the ministrations of the inflationists) ensures that after the bust the cycle is going to repeat.

Extraordinary Popular Delusions and the Madness of Crowds offers to the interested reader a colourful account of some of the most incredible historical episodes of collective folly. Doug French’s book Early Speculative Bubbles and Increases in the Supply of Money analyses the underlying economic causes of some of those same phenomena from an Austrian perspective. Gustave Le Bon’s and Humphrey B. Neill’s works are nice companions to the above books.

5. Extensive News coverage / Outlandish predictions

A useful rule of thumb is: whenever something has gone up so much that it makes for rosy newspaper headlines, then it’s time to sell it. 
The mainstream media are usually the last ones to jump on the aforementioned bandwagon: they need exciting stories that cater to a large audience, hence they all follow the latest fads. To make their products even more enticing, they generally add generous helpings of hype. 
It follows that the end of a bull run is usually accompanied by armies of cheerfully bullish journalists who regurgitate the most trite arguments to justify their (or some expert’s) shameless predictions, which usually prove to be just a stinky pile of rubbish. For a recent example, please watch this video (we want to warn our readers: even people with only half a brain will likely find it extremely annoying).

6. The initial trend change is met with scepticism (buy-the-dip mentality)

Since in the public’s mind a raising market can only go higher, all sell-offs and corrections are viewed as opportunities to get in. This belief has been reinforced during the course of the entire bull market, where all sell-offs and corrections were indeed opportunities. Unfortunately, this fails to hold true at the top, where distribution takes place: early participants (astute investors) sell their stakes to latecomers (your proverbial dentist). Countless investors have been ruined by buying one dip too much. 
This phenomenon is also due to the fact that the euphoric mental state that we discussed above acts as a filter that automatically prevents people’s brains from contemplating negative outcomes. Pride, the desire to be right and blind hope contribute to it as well. 
It’s important to note, however, that this generally happens only at the end of major bull runs in stocks, since commodities have the pesky attitude of crashing much more swiftly.


We hope to have provided our readers with a brief, to-the-point list of phenomena that usually accompany the end of a bull market. We’ll leave it to them to ascertain in which markets it is today possible to find all or most of them busily at work. 
We want to stress that these are helpful yet imprecise tools: they can’t endow an investor with the ability to spot exact tops; they can however help him in identifying approximate turning points, or at the very least moments when the risks of buying something greatly outweigh the prospective returns. 
Howard Marks’s last letter to his clients does a great job at explaining both the difficulties and the importance of being a contrarian: we suggest our readers save the PDF and peruse it every time they feel compelled to run with the herd. In investing what feels comfortable is rarely profitable and as the brilliant Ed Seykota once said “If comfort is your goal, stop trading.”

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