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Holy grail of investing

This article appeared in the January 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Use this technique to know when bear markets end, and bull markets start.

Photo of Michael Kemp By Michael Kemp, author

Sharemarket cycles, as characterised by shifts from periods of irrational exuberance to unjustifiable pessimism, have been a feature of sharemarkets since the first was established more than 400 years ago.

Which leads us to the Holy Grail of investing - the opportunity for an individual investor to profit by identifying, and acting in advance of, the changing phases of the market cycle. That is, to time the market.

Herein lies the problem. If it is irrational crowd behaviour that generates and amplifies the market cycles, it is the same behaviour that prevents us from stepping out of sync with the cycle itself.

To capitalise on the vagaries of the cycle we need to think independently, not in harmony with the crowd. Few people are capable of doing this; we are humans first and investors second.

But are there tell-tale signs at various stages of the cycle that might assist in our efforts to time the market?

A pioneer in the study of sharemarket cycles was Charles Dow, the co-founder of The Wall Street Journal and responsible for constructing the Dow Jones Industrial index in 1896. He did so to facilitate his observations of how the sharemarket moved.

After Dow's death in 1902, his observations were developed by others into what has become a popular model called Dow Theory, which is used to describe, explain and anticipate sharemarket movements. It describes the market as moving in recurring phases, identifiable by characteristic economic signals and investor behaviour.

Although identification of market phases is easier after the event, an investor who is able to recognise them as they unfold will be awarded a significant advantage in the timing of buy and sell transactions.

Identifying the end of bear markets

Unfortunately, while it is an ideal time to invest, it is never obvious when a bear market has ended. Typically it is noted after the event. Nor is there consistency in the timeframe over which bear markets run.

The average period of the past 10 Australian bear markets has been 15 months; they have varied between two and 32 months. At these times there is typically a prevailing mood of pessimism. It is this very mood, particularly if it is extreme that provides the cue to re-enter the market.

A classic example was provided when the publication Business Week ran as its cover story on August 13, 1979 an article entitled 'The Death of Equities'. It was the symbolic bell-ringing that preceded the longest and strongest bull market the US has experienced.

Similarly, in the week before Australia's relatively recent sharemarket low of March 6, 2009, the Australian Financial Review front-page headline said, 'Shares - End of the Affair?'. But just over a year later the market was 60 per cent higher.

A more objective signal to re-enter the market was proposed 50 years ago by US economist Edwin Coppock. His was a technical indicator designed to generate a buy signal at about the time a bear market had ended and the market was starting to recover. Although the signal it provides is not infallible, it does offer the advantage of objectivity.

The first stage of a bull market

Bull markets are usually born out of the depths of despair and at the very time when share ownership is shunned rather than embraced. It is this observation that led the renowned financier Nathan Rothschild to state: "Buy when there is blood on the street."

But few investors are willing to take the plunge at such a time. And as the market starts to recover, their hesitancy is reinforced by advice from commentators who warn against re-entering the market. They state their belief that what is being observed is simply a bear market rally.

True to form, this was the cry by many commentators during the early stages of our recent recovery. But counter to their claims, the market has since climbed strongly. History has demonstrated repeatedly that recoveries after heavy falls can be both substantial and rapid.

By way of example, the Dow Jones Industrial Average posted its largest annual increase of 54 per cent in 1933 within two years of its largest annual fall of 43 per cent in 1931. The Australian experience has been similar. We have seen 10 bear markets since 1960 as defined by a fall of 20 per cent or greater from a previous high. The average gain in percentage terms in the 12 months following the market bottom has been 34 per cent.

Many investors miss this early phase of a new bull market. They are hesitant, waiting to observe a recovery in prices, an improvement in sentiment and confirmation from the actions of other investors before they feel confident to re-enter the market. But missing out on this early rise can significantly reduce overall returns.

Identifying the end of a bull market

After the initial recovery, we see the second phase of the bull market. This is typically driven by renewed confidence, improvements in economic fundamentals and higher corporate earnings. The advancing share prices are usually justified.

However, the seasoned market timer is conscious of the potential for the market to become overheated. If share investment captures the public imagination, then market activity can develop into rampant speculation.

Commonly termed a bubble, irrational exuberance or mania, it is characterised by a wide divergence between the intrinsic values of shares and their market prices. The risk here is systematic, that the market will correct rapidly to the downside with little or no warning.

History has demonstrated time and again that this usually occurs exactly when most investors, market commentators included, are claiming that the high prices, as extreme as they might be, are totally justified by economic fundamentals.

Watch floats and margin lending

To the investor who can resist the tendency to be swayed by public opinion, there are characteristic signs that indicate when caution is required.

The first is simply observation of general behaviour. When there is a heightened interest in the sharemarket, particularly among people who otherwise would not show any interest at all, then it is time to take a reality check.

Two complementary signs are an unusually high number of initial public offerings (floats) and a significant increase in the use of margin lending to finance share purchases. Margin lending involves the extension of credit to finance purchases, using the shares themselves as security for the loan.

The greater use of margin lending often marks the mature phase of a bull market. In the eight years leading up to the October 1929 Crash in the US, margin lending increased nine-fold. Australia's record is similar. In the eight years leading up to the global financial crisis, margin lending here increased six-fold from $6 billion to $36 billion.

The fourth warning sign of an impending market correction is the most objective and relates to valuations. Established concepts of valuation are often discarded during rampant speculation. The principal motive behind share purchases becomes short-term capital gain rather than long-term investment; hence concepts of intrinsic value become widely ignored.

Claims of a new and sustained economic prosperity, typically described as a 'New Era', are made in order to justify the high prices observed. The term 'New Era' was used by press and commentators in the US at the time of the bull market peaks in 1901, 1929 and 2000. These claims could well have been substituted by the ringing of a bell, because on each occasion they preceded market collapses.

It was this same thinking that caused famed economist, Irving Fisher, to declare less than two weeks before the October 1929 Crash that US share prices had "reached what looks like a permanently high plateau". Subsequent to his claim, the Dow fell by 89 per cent.

And it is why Kevin Hassett, previously an economist at the US Federal Reserve, co-authored the 1999 book, Dow 36,000. Hassett claimed that the Dow was cheap in 1999 despite it being at its highest price-earnings valuation in its 103-year history.

My advice to anyone is that if you hear or read the term 'New Era' as a justification for high share prices, then sell everything - quickly.

Where we are now

Where are we now in the cycle? Australia, consistent with the rest of the world, has recently bounced back from a savage bear market. The Australian sharemarket fell by 55 per cent over the 16 months from November 2007 to March 2009.

We have since recovered nearly 50 per cent of the losses but are still well short of previous highs. The market currently offers some opportunities for the share picker, less so for the market timer.

About the author

Michael Kemp has had a long career in Australian financial markets. Following the release of his first book, Creating Real Wealth, in 2010, he now works as a freelance financial writer. Read more about Michael.

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