TheStar
The five phases of stock market cycles and where we are now
AS a result of the recent financial crisis in companies like Fannie Mae and Freddie Mac, Lehman Brothers as well as AIG, investors have been wondering whether there will be more companies affected by this crisis.
George Soros, in his book published in the early 2008 titled The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, said that “ .... the current crisis is not merely the bursting of the housing bubble. It is bigger than the periodic financial crises we have experienced in our lifetime.”
According to him, we should expect the current situation to get worse before it can get better.
Hence, investors need to prepare themselves for this downturn. Even though nobody will know exactly when the market will recover again, we must be ready when the market moves.
In order to do that, we need to understand stock market cycles and where we are now.
Stock market cycles can be divided into five phases €“ expansion, settlement, contraction, crisis and recovery.
During expansion, the overall stock market sentiment will be bullish with higher stock market volume and prices.
In every market rally, there is always a main theme. For example, the bull market in 2007 was mainly attributed to positive sentiment in the plantation sector.
During this period, we should buy stocks in the sectors that benefit from the rally. If your portfolio owned a lot of plantation stocks last year, you would benefit from the overall market rally last year. Hence, we should pick stocks that follow the market theme.
Then it will enter into settlement for some profit-taking activities. If the overall market sentiment remains bullish, it will resume its uptrend.
The bullish trend will reach a period where reality can no longer sustain the exaggerated expectations. Then the market will enter into contraction where long-term investors get very uncomfortable with the market situation.
In this period, we should sell poor fundamental stocks as well as stocks in sectors which will be seriously affected in a downtrending market.
There are still some short-term traders who may enter the market at this stage as they believe it may rebound later.
However, when the market drops further, it will enter into crisis where long-term investors as well as short-term traders are selling stocks.
Our market is currently in this phase where long-term investors as well as short-term traders are not willing to commit themselves. This is given the unsettling of the US financial crisis in companies like Lehman Brothers and AIG.
Despite the US government’s plan to rescue banks, not many analysts or fund managers are convinced that we have seen the worst.
Soros applied the theory of reflexivity to explain the current crisis.
According to him, the market participants’ misjudgements and misconceptions affect the stock market prices.
He said that later, these biased perceptions would affect both prices and the fundamentals that those prices are supposed to reflect.
When a market drops in prices, it creates fear. As a result of this fear factor, prices will drop further and later cause panic selling as the fundamentals will also be affected by lower prices. Then it will turn the investors’ perception into reality.
Soros called this a two-way reflexivity connection between perception and reality, which can give rise to initially self-reinforcing but later self-defeating.
Hence, in every stock market cycle, regardless of any stock market, while it may take a long time to reach its peak, when it drops, the drop will accelerate and be followed by panic selling.
At present, most investors will be eager to know when our market will enter into the recovery phase where the market will start to recover. It will be a mammoth job to predict the market bottom.
Nevertheless, we should consider buying some stocks whenever the market experiences panic selling like the recent global market crash on the fallout of Lehman Brothers and AIG.
According to Lauren C. Templeton and Scott Phillips in their book on Investing the Templeton Way, investors need to buy stocks whenever the market experiences panic selling.
They that we should take advantage of problems that are exaggerated in the minds of sellers because of the sellers’ near-term focus.
Even though they agree that buying into crisis may affect your portfolio performance, you will gain in the long term.
However, you need to make sure that you have enough cash to average down your purchases.
Ooi Kok Hwa is an investment adviser licensed by Securities Commission and managing partner of MRR Consulting.
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