Buy low and sell high', is the popular refrain chanted in response to the question of when you should get into and out of the stock market.
While this makes perfect sense - you buy your shares when they are cheap and sell them when you know you'll get a good price - how are you supposed to know at which point the market is overheated (the high) or whether it has bottomed out?
This is where monitoring investment cycles come in.
Stock markets move in waves over time. When markets are doing well - with companies reporting profits, share prices rising in correspondence and market-tracking indices reaching highs against a backdrop of good economic growth prospects, and low interest rates and inflation - they are referred to as bull markets.
Conversely, a bear market represents the downward trend, as prices come down, the economy loses steam and investors lose confidence.
In the USA, the most recent protracted bull run took place between 1982 until the dot-com bust in 2000. As Alex Berenson noted in his book about the history of markets, The Number: "Over the next 18 years, the Dow Jones industrial average and the Standards & Poor's 500 would both rise 15-fold. The Nasdaq composite index would rise 30-fold. And a few technology stocks would rise 1000-fold or more, making millionaires out of investors lucky enough to buy them early and smart enough to hold on."
Given the global village-like nature of the markets, with everything being linked, South Africa followed a similar plot: there was a bull market in the run up to the collapse of 1987, with a second taking place ten years later, says Alec Hogg in his book Shares: A Buyers' Guide.
How were you to know that you needed to sell out before the information technology bubble burst, leaving markets reeling and investors licking wounds?
An often-referred to method is the Dow Theory, developed by Wall Street Journal co-founder Charles Dow at the beginning of the 20th century. Although the theory has been refined, its basics still hold true.
According to Dow, there are three distinct stages in both the bull and bear market cycles; knowing where you are in the cycle and what the characteristics of that point are will go a long way to help you maximise your return. (The following information is taken from Hogg's book.)
The upward phase, known as the primary bull market, comprises three stages:
Accumulation - here, there is much negativity in the market and general economy. Shares have extremely low valuations, and almost nobody seems to want them. But those with patience start to take long-term bets. The "smart money" starts accumulating shares and despite the gloom, prices start rising slowly.
Big Move - easy money is made from shares. It is usually the longest period of the primary bull market and the time when prices rise the most and across the broad market. This period co-incides with an improving business cycle, company profits begin to rise again and valuations of shares improve. The professionals are fully invested in shares, and the investing public slowly starts to wake up to the trend.
Excess - This is the most dangerous stage of every stock market cycle. Confidence surges to extraordinary levels, interest rates keep falling, valuations of shares rise excessively and the public climbs into stocks as though they've discovered a secret path to quick money.
The primary bear market is also made up of three stages:
Distribution - just as the steady accumulation of stocks by long-term investors marks the early stage of a primary bull market, so the distribution of shares signals the stirring of the bear. Professionals start to realise that although business conditions remain favourable, they are not that good anymore and certainly do not justify the excessive ratings. Interest rates start edging higher again, not sufficient to break up the public's share market party which is in full swing, but loud enough to wake the bear from hibernation.
Big Move - This is the most painful time in any stock-market cycle for long-term owners of shares. The downward trend becomes entrenched, the fall in share prices being reflected in the economy where business conditions continue to deteriorate, earnings forecasts are missed or reduced across a broad range. Profit margins shrink, revenues fall and corporate profits keep dropping. All the while interest rates keep rising and bankruptcies increase. As the picture gets gloomier, the selling of shares gathers further momentum.
Despair - During this time, valuations reach rock bottom but even so, the selling continues as the public, which piled in during the excess stage, wants out at any price. News from the corporate sector is bad, and the economic picture is bleak. The market keeps falling, usually going lower than even the pessimists believe possible.
Moneyweb
26 May 2009 03:57
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