MARKETS make opinions. You can’t get closer to the point than that. “Markets make opinions” should be the most common investment cliche, before “buy low, sell high”.
What this phrase means to the study of market cycles is profound, because the ever-turning market cycle depends more on the mass mind and its thought patterns than most people realize. Instead of objectivity and rational analysis at the top and bottom of the business cycle, you find unbridled optimism after stocks take flight, and outright disgust when they land in a hurry back on earth.
Simply put, stock market cycles reflect the collective error rate of investors. At critical turning points, millions of mistakes occur. In fact, it often seems the market does what it must to fool the maximum number of investors at any given time.
So it’s important to consider what people are thinking, because at every stage of the cycle, the crowd’s reaction to unfolding events determines the fate of the cycle itself.
The four quarters of the cycle
For the sake of illustration, I’ve divided the continuous market cycle into four discrete stages. Later, when I introduce the Red Wheel, I’ll put them back together.
Bear in mind that cycles vary in strength and length. Booms beget busts in proportion to themselves. The bigger the cycle, the greater its impact on the economy and society. Also, the four stages of the cycle are not equal. Stage One begins at the lowest point, and is the shortest; Stage Two is the longest, and ends at the highest point. Stages Three and Four occur in the downmove, half as long as the upmove on average.
Let’s look at each stage of the process in finer detail.
- After a frightening sell-off, the market hits bottom, and by definition the upturn must begin.
- Redeemed by the fall, the market is reborn. It quietly makes a fresh start.
- Few investors can take advantage of the low stock prices. Even fewer are willing.
- During the dawn, resentment, shame, and hopelessness plague the market.
- The speculative mood is absent. Gloom dominates.
- Investors shun the sectors they once loved in the boom.
- Caution, austerity, humility set the tone. Buyers expect even lower prices.
- It’s back to basics: work hard, save money, build for the future. Investors prefer bonds.
- People want reform and redress, so Wall Street loses power and governments gain it.
- Regulators punish a few villains.
- From small beginnings, the rally picks up as the cycle rolls on.
- The economy brightens. The system heals. It’s a new day.
- Investors look at the market’s recovery with disbelief bordering on derision.
- Corrections are short and shallow, frustrating late entrants.
- Confidence increases as stocks rise. To their later regret, some investors take profits.
- Businesses grow and become more profitable. The economy is on a roll.
- Reports of astonishing stock performance arouse the average investor.
- The hottest sectors attract giant inflows of capital.
- Great new ideas, high returns…it’s a good feeling, a golden moment.
- Public cheer gives way to self-indulgence. Sales of yachts, jets, and luxuries expand.
- Transactions speed up, whether takeovers, house purchases or new projects.
- Financial news focuses on the activities of aggressive speculators. Wall Street booms.
- The economy runs hot, stoked by carefree business and consumer spending.
- Real estate, art, antiques, wine and collectibles appreciate.
- Feeling on top of the world, investors enjoy their day in the sun.
- Top earners, praised for their acumen, grow arrogant and overreach.
- Impatient capital flows into trendy, ill-fated investments.
- Wretched excess and a feeling of invulnerability prevails.
- Then, at the point of maximum optimism, the market peaks.
- After the peak, prices have nowhere to go but down.
- As for the experts, they reject and discredit warnings of collapse, but are open to a plateau.
- The flow of new money into the market starts to dwindle.
- Suddenly, and without obvious reason, stock prices fall.
- Subtle signs of unwinding begin. The reckless binge of wealth and glory is no more.
- Public figures issue soothing expressions of encouragement.
- Cries that stocks always perform in the long run echo down Wall Street.
- Stocks fall again, convincingly this time, and break the spell.
- As the cycle enters the underworld, a chill descends on economic life.
- Time passes, but the situation gets worse, not better. The overindebted go under.
- Investors rush to sell stocks and stock funds.
- Banks curtail lending. Businesses cancel projects.
- Prices come down harder and faster than they went up.
- Shocked and humiliated by the relentless declines, investors lose faith in Wall Street.
- Bankruptcies, layoffs, and losses fill the news. Headlines mention the Depression.
- High-flying heroes fall back to earth, their fortunes reversed.
- Cases of embezzlement, fraud and malfeasance surface. Public anger mounts.
- Defective investments reach their natural end, bringing grief, regret, and bitterness.
- As sellers grow ever more urgent, and buyers lose heart, expectations fade to black.