When? That’s what everyone wants to know. The answers to why a bull market ends come pouring in the second the when is confirmed.
But the explanations why are usually complex. They certainly won’t help anyone predict the next turn. They’re often secondary, or scapegoats, to what really happened.
The 1982-87 bull market is a good example. The five year period saw steady gains in most quarters: only 5 out of 20 quarters were negative, with no declines of as much as 10%. And 1987 started off hot, up 21% in the first three months, before peaking in August.
The bull market that culminated in Black Monday ended because…Computers! Computerized trading, that is. That one gets piled on all the time. Portfolio insurance and leverage also got blamed. And they sound good too.
Except, they’re all secondary reasons that better explain the depth of the decline, not the trigger.
A month after the crash, Peter Bernstein offered a simple answer to what triggers the end of all bull markets:
What was the secret ingredient that kept investors buying and buying at higher and higher prices? Was it the myths that this market, like all bull markets, created to justify itself? Was it the belief that the Japanese were coming, that raiders paying stupendous prices knew value best, that buy-backs were a viable substititue for dividends, that portfolio insurance would save the day for risk-takers, and most typical of all, that bull markets always climb a wall of worry?
Although the myths helped keep the pot boiling, the basic explanation for the bull market’s longevity and vitality in the face of so much economic difficulty is simpler, more fundamental, and more easily generalized. The same simple, fundamental explanation applies to the bull market’s sorry end as well.
The common thread that runs through all equity bull markets is confident expectations of higher earnings ahead. The common thread that ties the onset of all bear markets together is the loss of those confident expectations of higher earnings ahead. History shows us, over and over, that bull markets can go well beyond rational valuation levels as long as the outlook for future earnings is positive.
Bull markets require economic slack so that companies can grow, and positive trends in real business activity to take advantage of that slack. Remember, stock prices show no consistent relationship rates, exchange rates, inflation rates, budget policy, monetary policy, or any of the other things we professionals love to discuss. These forces matter only when they matter to the future movement of corporate earnings.
Confidence can be very subjective and hard to measure, especially outside of the extremes. Even then, trying to time the shift is no easy task. As Bernstein says, valuations can stay irrational as long as confidence stays high.
Those same irrational valuations that seem to defy gravity spur the “myths” that get investors into trouble. The big mistakes — overconfidence, trivializing risk, chasing returns — can leave investors under-protected for what inevitably comes next. Overpaying for (optimistic) future earnings never ends well.
The important thing is to recognize the role confidence has on market prices and the obvious risk of getting caught up in the excitement.
A Simple Story – FAJ 1987
Ben Graham on the Risk of Bull Market Optimism
Seth Klarman on Being Ready for What’s Next