I’ve been writing for the past couple of days about minor, counter-trend moves in stock prices.  I figure I might as well continue on this topic by writing about the characteristics, as far as I know them, of major changes in market directions–market tops and market bottoms.

This will be the first of three posts and will cover general stuff.  Market bottoms will come next.   Market tops, for me a far more difficult topic, I’ll try on Thursday.

general

shape

Stock market indices have long been considered good leading signals for the direction of the overall economy of a country.  In the US, for example, it’s one of the more reliable of the set of indicators economists use to chart economic progress.  The cliché is that the market leads the real economy by about six months.

While that may be true in on average, I’d add one refinement:

the market’s discounting mechanism, that is, what future events the market is willing to factor into today’s stock prices, varies with the business cycle.  In a bear market, investor optimism contracts sharply, to the point that at the bottom investors are only willing to pay for the here-and-now–and will sometimes even demand a discount price to book value; they won’t pay for what they consider a risky future at all.  On the other hand, in the later states of a bull market, investors are happy to pay for earnings two or more years in the future, even though there’s no evidence that professional securities analysts can project earnings accurately one year ahead.

time

As a practical rule of thumb, the classic inventory-adjustment business cycle is a four-year phenomenon.  During a boom, the money authority sees that a country’s entire industrial capacity is being utilized, more capacity is in the works, the labor pool is almost completely empty and firms are beginning to poach employees from each other by offering higher compensation packages.  In other words, the economy is starting to overheat.

The central bank responds by raising short-term interest rates.  That slows the economy markedly and a mild recession ensues.  At some point, probably about eighteen months later, the monetary authority concludes the economy has cooled down enough that rising unemployment is a bigger danger than inflation.  It reverses course and begins to lower rates.  This starts the upcycle again.

In this simple world, where there are no external shocks and no egregious policy and regulatory blunders (don’t we wish!), the rhythm of the economy is:  two and a half years of up, followed by one and a half years of down.  The rhythm of the stock market is close to the same.

Three practical rules derive from this picture:

1.  two years into a bull market, start to look for signs that the end of the good times may be near,

2. after one year of down market, start getting ready to buy, and

3.  look to the monetary authority for confirmation of a change in trend.  Under normal circumstances, however, industrial capacity utilization and the unemployment rate will lead central bank action.  So look at them first.

the “real” world of the past fifteen years

You’re probably thinking that this simple timing rule wouldn’t have done a lot of good during the collapse of the speculative internet market of the late Nineties or the popping of the housing bubble a few years ago.  That’s absolutely right.  However, the mistakes of the Greenspan Fed have had  common effects on stocks.

In addition to intensifying the ups and downs, they’ve also stretched the market cycle time frame to 3+ years of up and  about 2 years of down, but they haven’t altered the basic shape.  And (let’s hope) the present Fed has learned from the havoc the “maistro” has wreaked.  So it’s possible that once economic recovery in the developed world gains strength, we’ll revert to the older, more benign pattern.

Be that as it may, I think we can draw one important conclusion.   Market history suggests that right now, with the world about to enter year three of uptrending stock prices, we’re only reaching the earliest stages of having to think about how and when the current bull market will end.