Market Cycles: From Bull to the Bear Phase

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Market Cycles: From Bull to the Bear Phase
<a href="https://pixabay.com/users/harpsandflowers/">harpsandflowers</a> / Pixabay

Market Cycles: From Bull to the Bear PhaseI wrote a piece with the same title four months ago, but this one will be different, because I want to focus on individuals, and less on institutions.  During the bull phase of market moves, people are willing to take chances.  That can take several forms:

  • Being willing to buy speculative companies
  • Lengthening the time horizon: buy-and-hold.
  • Committing to debt, or even just lessening cash reserves, to own assets like houses, cars, second homes, boats, furniture, etc.
  • Being willing to buy illiquid assets like art, private equity, hedge funds, etc.

This applies to institutions as well, because they also give into the boom-bust cycle.  They are willing to speculate in good times, and seek safety in bad times.

But for individuals, time horizons sum up asset behavior whether it is investing or buying consumer durables.  Willingness to part with cash lengthens time horizons.  Those with short time horizons hang onto cash.  But often the same people change from having a long time horizon to a short time horizon and vice-versa, and at the wrong times.

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The delicious perversity of markets — they incline you to do the wrong thing at the wrong time.  Have I been taken by this?  Yes, but not as much as many, because I don’t trade much.

Optimism creates long time horizons; it simplifies thinking.  “Let the market pay your people.”  “Cash is trash.”

Pessimism creates short time horizons; it simplifies thinking.”I’m going to stick with my money market fund.”  “I will keep my savings in gold.” “I will buy long Treasuries because I want cash flows that are certain out in the future.”

Time horizons are a symptom of the bull/bear cycle.  During bull phases, people commit capital for long time periods.  During Bear phases, periods shorten to the degree that many hold only cash.

To some academics this will seem unreasonable.  People are rational, aren’t they?  They don’t regularly make bad decisions, do they?  Sorry, but with economics, the answers are no and no.  The assumption that people are rational is not proven.  A far better assumption is that people try to justify themselves, whether they succeed or not.  Winners proclaim their brilliance.  Losers blame the umpire.

Yes, people regularly make bad decisions, and those brighter than them sporadically benefit.  It is hard to buy at the bottom, but a few do.  It is hard to sell at the top but a few do.  Note: those “few” are not the same people, because native bullishness or bearishness overcomes.  No one consistently gets out at the top, and in at the bottom.  But many get out at the bottom, and in at the top.  That is the way the markets work.

You might argue that this increases inequality and is not fair.  I’m sorry, but this is fair because people misjudge the underlying businesses, and they don’t keep adequate cash around as a margin of safety.  The equity market is only for those who keep an adequate reserve of safe assets around.  It is too dangerous for anyone else.

Stocks do not reward people year after year.  It comes in fits and spurts.  That is as it should be, and get used to it.  Those who don’t have long time horizons should reduce the amount of stocks they hold, unless valuations are low, and that’s not true now.

This is a time to be cautious, and reduce exposure to risky assets.  Given the global troubles, be wary, because little things like Cyprus could prove as small as subprime, which was declared “well-contained” by someone who didn’t know which end was up, and still does not.

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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