Stock Market Cycle - Bubble in Bull Markets

In a complete stock market cycle, fundamental Investors tend to look at bull markets as a bubble. When the bubble is inflated, bull markets tend to slow down a little which is what known as market correction. For long term stock investors, even if the stock prices go down a little during market correction, it is still not a very good time to buy stocks.

The perfect buying opportunity for them will appear in a real economic recession and not through market correction in the bull markets. To have an economic recession, economy or corporate earnings have to go down or an unexpected event has to take place.

In bull markets , P/E starts to rise from a single digit to the twenties, then thirties, forties, fifties or even higher.

Some value oriented speculators begin to change their valuation criteria, switching to a relative form of value. They compare the stock’s P/E values of different companies.

They will buy the stock as long as the value is lower that the highest P/E. For example, if the P/E of stock ABC is 50 whereas the P/E of company XYZ is 40, the speculators would believe that company DEF is offering cheaper valuation. Without considering the stock’s earnings power, they simply buy the stocks from the relative value.

And even the fund managers are doing this in the bull market. Some of them believe that profits are not their top priority anymore in choosing stocks. Instead, total sales or revenue is more important even if it is losing money.

When most stock analysts proclaim that earnings are no longer important in valuation, the bull market is actually in its final phase. In this stock market cycle, the bubble begins to show the sign of bursting. At this point, most fund managers are following technical analysis and stock charting than monitoring its business performance.

You will see mutual funds reporting more than 30 per cent returns. Most people jump into playing a market momentum game. Technical analysis becomes the favourite stock investment approach.

Fund managers who use value approach or fundamental analysis, will not be able to get 30 per cent returns. They either join the momentum investing game or they are driven out of the business, simply because their investors are opting for another fund with higher returns.

When more and more speculators jump into the game because of greed, more and more money gets pumped into the stock market. Stock prices go up across the aboard making everyone feel rich. Housewives, engineers, teachers, lawyers, hawkers and doctors are all talking about stock investment.

Public that feels rich acts like it, spending money like crazy, which help heats up the economy. An overheated economy results to high in inflation. When the time comes, government will step in to raise interest rates. If there are raised high enough, they will eventually burst the bubble. In this high interest rate environment, the market will eventually fall.

When the bubble burst, a couple of things can happen. The country may slip into recession. You will see layoffs and falling corporate profits. Government will slowly reduce interest rates trying to revive the economy. The immediate impact of lower interest rates will be an increase in car and house sales again. Seeing this, investors will anticipate the economic revival and jump back to the stock market.

This time though, they will be investing in the blue chips that have strong earnings. They will not chase after the once hot bubble stocks anymore.

If the drop in interest rates does not revive the economy, the country will slip into an economic depression. During this stock market cycle, stock prices will really head south as if there were no more supports for the stocks. If the recession happens, the stock market will be the best shopping mall in the world.

Look, I don’t want any widespread recession happening in our country, but if it were happening, it would be a great opportunity to high quality stocks at a bargain price. At such time, invest in the quality companies that were very profitable before the recession.

In an industry wide recession, everyone gets hurt, but in the end, the strongest survive whereas the weakest went bankrupt.

Any company with a durable competitive advantage will eventually recover after the market correction or economic recession. However, some companies may take years to fully recover. Since the technology or dot com crash, public listed information technology companies have yet to recover from their all-time high.

On the other hand, if you buy good stocks in during the bad times, it will not take you long to make a fortune. So, get ready to face this stock market cycle, and you don’t have to wait another long years!

Highly Recommended FREE Sign Up