How and Why Markets Move—Section 12
The stock market moves in cycles because the U.S. and world economy moves in cycles from expansion to contraction and back to expansion. This is reflected in the price of stocks. As the economy expands, employment increases and the demand for goods and services grow. This increases corporate earnings and profits which is reflected in higher stock prices. The opposite occurs during an economic contraction. Unemployment increases and the demand for goods and services weakens. Corporate earnings and profits decline which is reflected in generally lower stock prices.
The stock market, however, does not react to economic conditions, it anticipates them. What occurs in the stock market today is a reflection of investors expectations of what will happen in the economy several months from now. No one can see the future so these expectations are sometimes wrong. However, the institutional players, who really drive the markets, are some of the best informed people in the world. Because of this, the stock market is a good barometer of future economic activity.
A bear market actually begins at the top of the previous bull market. Stock prices have been rising for several years and may be high relative to company earnings. Late comers, usually the least informed investors, join the market in hopes of quick profits. The best informed investors, who usually work for large financial institutions, use this increased market participation to unload shares purchased much earlier in the bull cycle in order to lock in profits.
Market tops are often characterized by increased volatility in the form of large daily price swings. This increase in volatility is a reflection of excessive fear and greed. Some players are fearful of losing their accumulated profits, while others are fearful of missing out on profits to come. This volatility can be exacerbated by programmed buying and selling which can dramatically increase the supply and demand for stocks.
Usually at around the time of the market top, negative economic news begins to accumulate. This is due to the cyclical nature of the economy. The smart money, which is leaving the market, has anticipated this news and is aware of its importance. The less informed investors entering the market typically don’t have a clue as to what is likely to occur. They only know that the market has been going up for a long time and that they want a piece of the action.
Over time, the negative economic news has its effect resulting in a sharp sell off. After the initial sell off, which can last for weeks, the market may attempt to rally because not everyone, including many professionals, are convinced that the bull market has really come to an end.
In a true bear market, the rally will be stifled by the semi-smart money that did not get out of the market at the top. These people are grateful for a second chance to leave the market with some of their profits intact. The increased supply of stocks dumped on the market by these investors overwhelms the demand that caused the rally. As a result, the rally fails to exceed previous highs and the market resumes its decline. This time, however, the decline exceeds previous lows. This cycle of lower highs and lower lows may be repeated many times as the market mood shifts from concern to fear and ultimately panic.
During the panic stage, many mutual fund holders and small investors liquidate their stock holding, usually at a substantial loss. By this point, people simply want to get out of the market at any price, just to stop the pain. The technical name for this behavior is capitulation and often signals a market bottom.
Eventually everyone who is going to sell has sold and the market stabilizes at a level much lower than the previous high. This may also be due to the institutions holding a basket under the market. That is, they are willing to soak up the available supply of stocks because they are buying them at bargain prices.
The bottoming process may last for many months with supply and demand being approximately even. Gradually, again because of the cyclical nature of the economy, positive economic news accumulates and corporate earnings and profits begin to improve. Stocks become more attractive and the demand for stocks slowly increases. By fits and starts, stock prices begin to increase with higher highs and higher lows. At some point it becomes apparent that overall market trend is up and a new bull market is born.
The bull and bear market cycle have been repeating itself for hundreds of years but always in a somewhat different form. This makes it difficult, except in retrospect, to see exactly where bull or bear markets begin and end.
Quiz—Section 12
1.The U.S. and World Economy moves in cycles from
A) contraction to contraction to expansion
B) expansion to expansion to contraction
C) expansion to contraction to expansion
2.The stock market ___________ economic conditions.
A) reacts to
B) has no bearing on
C) anticipates
3. What factors often are associated with stock market tops?
A) Stock prices are high relative to company earnings.
B) Increased volatility in the form of wide daily price swings.
C) Several years of increasing stock prices.
D) All of the above
4.Bull and bear markets are caused by:
A) the cyclical nature of the U. S. Economy
B) greedy Wall St. speculators
C) Sun spots.
5.During the panic stage of a bear market investors typically _________. Select all that apply.
A) calmly and coolly evaluate their investments
B) sell first and ask questions later
C) Look for buying opportunities
6.As events are unfolding, it is easy to spot the beginning and end of bull and bear markets?
A) True
B) False
Securities offered through Registered Representatives of Cadaret, Grant and Co., Inc., Member FINRA and SIPC, 239 New Rd, Parsippany, NJ Registered Representatives are licensed to conduct securities business in NY, NJ, PA, MA, CA and FL. Bauman, Noonan and Associates and Cadaret, Grant and Co., Inc. are separate entities.