Market Breaks Out – Is This The Mania Phase?

During the course of the past two months, I have been regularly discussing the market consolidation that began in early February.  (Here for latest and archives) In that weekly analysis, I posted the following chart which showed the two most probable outcomes of the current consolidation process.

The breakout above 1900 yesterday brings into focus the potential for a continuation of the current bull market cycle.  However, with the market very overbought in both the short and intermediate term, it is unclear how far the advance will go considering the drag from reduced liquidity inflows by the Federal Reserve.  This concern is not unfounded as we have seen this particular set up (overbought conditions with reduced liquidity) previously in 2011 as QE 2 came to its conclusion.

I am NOT suggesting that the current market cycle will exactly replicate the 2011 experience as there have been enough market period chart comparisons as of late. However, what I am suggesting is that a similar "set up" had a negative consequence and the current market cycle should not be taken for granted. Markets don't repeat, but they do rhyme quite often.

With the current bull market now stretching into its sixth year; it seems appropriate to review the three very distinct phases of historical bull market cycles. 

Phase 1) “What bull market? The fall is right around the corner”

Following a massive, mean reverting, correction – markets tend to bottom and begin an initial recovery. Most individuals have been crushed by the previous market decline and only recently “panicked sold” into cash.

There are many signs during the initial phase that a new bullish uptrend has started.  Money flows from defensive names in order to chase higher yield, market breadth is improving, and volatility declines substantially. 

However, despite those indications, many individuals do not believe that the rally is real.  They use the rally to sell into cash and angrily leave the markets or continue to stay in cash expecting another failure.

Note: The fastest price appreciation in the market happens during the first and third stages of the bull market.

2) Acceptance stage

During the second phase individuals gradually warm up to the idea that the markets have indeed bottomed the psychology changes to one of acceptance.  At this point, the market is generally considered “innocent until proven guilty.“

The overall psychology remains very cautionary during this second phase.  Investors react very negatively any short term market correction believing the bull market just ended.  They continue to remain underweight equities and overweight defensive positions and cash.

During the second phase stocks continue to climb higher and market corrections are short-lived.  It is between second and third phases that a deeper market pullback occurs.  This pullback tests the resilience of the rally, shakes weak hands out of the market, and allows for new bases to be formed.  This deeper pullback is used as a buying opportunity by institutions, which missed the initial stages of the rally, and their buying continues to push the markets to new highs.

3) Everything will go up forever

During the first phase, most individuals remain skeptical of a market that has just gone through a high-correlation, mean-reverting correction.  It is at this point that most investors are unwilling to see the positive change in market dynamics.

In phase two, however, investors gradually turn bullish for the simple reason that prices have been steadily rising for some time. Analysts and strategists are also turning universally "bullish" in an attempt to manage their career risk and attract investor dollars.

In the final phase of the bull market, market participants become ecstatic.  This euphoria is driven by continually rising prices and a belief that the markets have become a "no risk opportunity.”  Fundamental arguments are generally dismissed as "this time is different."  The media chastises anyone who contradicts the bullish view, bad news is ignored, and everything seems easy. The future looks "rosy" and complacency takes over proper due diligence.  During the third phase, there is a near complete rotation out of “safety” and into “risk.”  Previously cautious investors dump conservative advice, and holdings, for last year’s hot “hand”  and picks.

The chart below shows these three phases of the bull market over the past three market cycles.

Note:  I have highlighted with blue vertical lines the deviation between current prices and the linear trend of the index. The current extreme price divergence is not indefinitely sustainable.

While the current bull market remains "bulletproof" at the moment to geopolitical events, technical deterioration, overbought conditions and extremely complacent conditions; it is worth remembering what was being said during the third phase of the previous two bull markets:

• Low inflation supports higher valuations
• Valuation based on forward estimates shows stocks are cheap.
• Low interest rates suggest that stocks can go higher.
• Nothing can stop this market from going higher.
• There is no risk of a recession on the horizon.
• Markets always climb a wall of worry.
• "This time is different than last time."
• This market is not anything like (name your previous correction year.)

Well, you get the idea.

Are we in the third phase of a bull market?  Most who read this article will immediately say "no."  But isn't that what was always believed during the "mania" phase of every previous bull market cycle?