We’d all love to know when a bull or bear market is going to end. Unfortunately, that’s nigh on impossible.
However, the recent announcements that central banks in Japan and China are trying to stimulate their economies suggest the current bull market in US stocks might keep going a while longer.
But beware. The sheer volume of liquidity (courtesy of those increasingly desperate central bankers) is what’s keeping markets afloat. Meanwhile the real economies around the world sink. It also means it’s impossible to gauge just how high share prices go before the inevitable and sudden downturn I see coming.
Investor amnesia on the last point — an inevitable and sudden U-turn — is an affliction that happens at the height of every boom. Investors seem to think the boom and bust cycle has been magically replaced with a boom and even bigger boom pattern.
How else, other than investor amnesia, can you explain the increased flow of funds into a market in the months prior to a boom period ending? This has happened without fail in every boom in history.
All investors, irrespective of their risk profiles, need to recognise that at some point the disconnect between soaring markets and a sagging economy is going to be re-connected.
When this happens, markets will exit the highway of steady returns central bankers have paved so far since the GFC. Markets will soon head downhill on a steep, bone-jarring dirt track.
History (and a good dose of common sense) can only serve as a guide as to what lays in wait for us down the road. Some well established principles are:
A bust always follows a boom.
The higher markets rise on euphoria, the greater they plunge on despair.
Printing money does not create economic prosperity. If it did, Zimbabwe would be the world’s richest nation (on a per capita basis).
Stability leads to instability.
There are no new ways to go broke. At the heart of it, it’s always too much debt.
Market values are (in the long term) a reflection of a sensible multiple being paid for earnings. Multiples (P/E ratio) can and do go to extremes (high and low) but eventually there is a reversion to the mean (a sensible multiple level). The collection of multiple data points is how the process of an average P/E is created.
The following chart puts the current bull market (red line) into historical context. It is the fourth longest in history.
Source: Financial Times
The third longest was after the Second World War — lasting from 1949 to 1956.
The two longest bull markets — ranging between seven and eight years in duration — both ended very badly. The longest bull market in history was during the Roaring 20s. The second longest was during the ‘tech boom’ of the 1990s.
The fifth and sixth periods ended badly as well. The fifth was the five year period beginning in 1982 leading up to the 1987 crash. The sixth was the five year period starting in 2002 that delivered us the GFC.
The annals of market history recognise the two longest running bull markets as periods of excess and exuberance — criteria that pre-ordain a bad ending.
If history is a guide, it’s possible the current market is only partway through its journey. There could be a further two years or more left in the current market. However, history also tells us extended bull markets, with excess credit and euphoria driving them, end with a significant downside…that’s losses of 50% or more.
Excluding the 1949 to 1956 bull market, each previous significant market downturn has wiped out years of boom time gains (see the S&P chart above).
When, not if this market decides it’s time to invoke the law of ‘reversion to the mean’, it is a very real possibility all gains made since the 2009 GFC low point will be vaporised.
What do you do? Well, it’s the same principle you’d adopt if you were driving on a road you knew had a blind U-turn ahead. You’d begin applying a little caution…slow down to a reasonable speed and begin applying the brakes.
We know the Pavlovian response of the crowd. They buy in the more markets rise.
Do the opposite. Start selling down your share holdings to a level you’ll feel comfortable with if it halved in value. Prepare for the inevitable U-turn…it is coming. Perhaps not tomorrow, next month or even next year. But it is coming. And when it does, the principle of the higher you rise, the harder you fall is almost certain to apply.
If, on the other hand, you do buy into central banker omnipotence and boom followed by boom followed by boom, then stay in the market. I’ve no doubt there are plenty of advisers who’d love to chat with you about the merits of margin lending into this new, history making market paradigm.
The crash on the highway is not going to be pretty. There will be fatalities, serious financial injuries and timetables to retirement postponed indefinitely.
To avoid being caught in the carnage, play it safe. Ease up. Build a big enough buffer of cash to withstand the bone-breaking impact of the collision between markets and economic reality.
For The Daily Reckoning Australia