It may well be the most-hated stock market rally in recent history. Every time we hit a new high, as we did this week, investors brace for the next pull back. When the declines do occur however, they are shallow and soon recover. What is that telling you?
Let’s look at recent history. The stock market has been climbing steadily since November, shortly after President Obama was re-elected. Each month since then the markets have made impressive gains followed by short, shallow declines. Wall Street calls that a stair-step rally. Investors have purchased equities on every dip including the last “Taper” sell-off in May through June engineered by the Fed.
Unlike every year since the great financial crisis, this year stocks have yet to experience a 10% decline or greater. The last one amounted to 8.8% and yet here we are, less than two weeks later, enjoying a new, record high on the S&P 500 Index. So why are we always looking over our shoulder for the next collapse?
I believe a great deal of investor anxiety can be traced back to the horrendous losses most of us experienced during 2008-2009.
We think that experience has scarred us. But if one looks back through history our reaction is predicable. You see, the psychology of investors in each market cycle is remarkably similar. Picture the stock market’s direction in the shape of a bell curve. On the extreme left side the market is bumping along the bottom and begins to rally. There is great volatility (think of the last few years) as the market climbs. The gains are met with disbelief by the vast majority of investors. “This rally will fail like the others” is a common refrain heard during this period.
Yet the market continues to climb. The corrections along the way become shorter and less painful. Some begin to hope. Could a recovery really be in the cards?
Hope blossoms into optimism as the markets continue to move higher. The economy is improving. The unemployment rate is declining. The deficit is dropping. Even the Fed is telling us that things are getting so much better that they are considering tapering their stimulus program. At this juncture, we are about 33% up the left side of the bell curve.
What happens next?
We begin to believe. It is the sweet spot of stock market gains. The bell curve steepens here, the gains come faster and the corrections fewer and further apart. It is the belief stage of the market cycle. That is the time most of us become fully invested. It doesn’t happen all at once, but as even the most fearful among us begin to believe they begin to invest adding fuel to the rally.
It is a time when the more speculative companies and sectors begin to outperform. Cyclical, consumer discretionary and technology are some of the sectors that come to mind. Mid- and small-cap stocks start to garner attention as the more defensive large cap areas begin to lag.
Sometime in the future belief will give way to the ‘thrill of it all’. That’s when the conversations at cocktail parties and BBQs are all about the latest stock to buy or how much Sarah made on that last trade. Euphoria begins shortly thereafter. At that point, everyone in the market is a genius. It’s when you start believing that you could actually retire next year if things keep climbing.
At that point you are at the top of the curve with only one direction going forward–down. Don’t worry, I will be happy to inform you when we get there, but I believe that could be some time in the future, long after you have forgotten this column. In the meantime, there is only one question to ask. Do you believe?