3 Waves of a Bull Market

Bull markets tend to evolve in 3 waves.  The first phase is when the “smart money” and institutional investors are buying at relatively low valuations, typically following a bear market, that ends a decline starts a steady push higher.  The second phase is when the media finally catches on after noticing that a market has been climbing higher which starts to draw in other investors.  The third phase tends to be an acceleration as euphoria takes over and enthusiasm turns to greed and eventually mania.  The third phase can accelerate into very large movements in a very short period of time.  For example, in a bubble, you can see a market double in less than a year.

Here are some examples from the past to illustrate how the slope of the climb steepens over time to illustrate the acceleration of the move.  All of the following charts are of the Dow Jones Industrial Average on a log scale to “normalize” the chart for percentage changes.

1920’s advance preceding the Great Depression:

1980’s advance preceding “Black Monday” crash:

1990’s bull market.  Notice the smaller 3-wave phase that makes the 2nd-wave of the broader, decade long 3-wave phase.  This illustrates the fractal nature of markets:

2004-2007 bull market that preceded the housing crisis:

There were other, more abbreviated moves of a similar nature in the 1940’s and 1960’s as well but the charts above illustrate the point well enough.  Despite a similar construct, every bull market is different.  Some start from low valuations and therefore tend to last a long time.  Other’s start from higher valuations and are more abbreviated.  Also, the macro forces fueling each bull market tend to change over time.  The current global economic environment is extremely reminiscent of the 1920’s when Europe was decimated by World War I and capital poured into the US, fueling the “roaring 20’s” and a massive bull market.

Unfortunately, there’s no way to tell what’s to follow.  1987 ended with a sharp crash that reset the system but valuations were still low, the Fed was aggressively lowering interest rates and the economy was experiencing strong growth so it ended quickly and immediately began a new bull market that lasted all the way through the 1990’s.  The 1990’s bull ended with very high valuations that needed time to work off so the ensuing bear market was very drawn-out, lasting about 3 years and dropping 40% to 50% (depending on the index). 

So where do we stand today?  The move higher since the election is starting to feel like we’re accelerating higher.  The current global economic environment and flow of capital reminds me very much of the 1920’s (Europe having major problems and money continues to pour into the US) so it’s not out of the realm of possibilities that we see the US stock market move a lot higher.  However, we’re at extremely elevated valuations already so an accelerated advance would be a warning to me that we’re in the final blow-off phase.  There’s no telling how high it can go or how long it can last, but I will certainly be reducing exposure to stocks if we continue to pick up steam to the upside.

Current Bull Market:

Also, the internal breadth of the market looks weak as fewer stocks are participating in the advance.  This tends to be a warning sign.  The push higher following the Brexit vote at the end of June was fairly broad in terms of participation so another advance was expected following the consolidation this fall, but this recent rally is quite narrow (Chart Below: higher market price (black line) vs fewer stocks rallying (green line)).  We’ll either need to see broader participation or expect a larger pullback in the near future to reset things – which I would view as healthy for the market.  Again, it’s a rapid acceleration higher that we don’t want to see.

For any do-it-yourselfers out there looking for a simple way to track the market and know when to reduce exposure to stocks, just follow the market in relation to its 10-month moving average (MA).  You can pull this up on any free financial website that allows charting – like yahoo finance.  Meb Faber of Cambria Investment Management has done some great work on tactical asset allocation using the 10-month MA.  I always prefer to use the exponential moving average (EMA) over a simple moving average (SMA) but they’re pretty close.  Click here to read a paper Meb wrote a few years ago on using the 10-month SMA to help with portfolio positioning decisions.

Here’s a chart of the S&P 500 with its 10-month EMA (red line).  You’ll occasionally get hit with some whipsaws (false warning signals that we recover from), like we did twice over the last year and a half, but that’s the cost you pay to make sure you don’t experience a huge drawdown like 2008.

Only time will tell where we go from here!

-Nick