The Ageing Of A Bull Market — April 2014

April 28, 2014

Dow Jones Average: 16,361
S&P 500 Index: 1,863


The Ageing Of A Bull Market


Financial markets go through cycles that have certain characteristics and patterns particular
to each phase of the cycle. Bull markets typically start out with a youthful sprint higher, go
through a muddled middle phase, and a final, frenzied surge before stumbling into old age.
The typical bull market has historically lasted for just over four years. In recent decades
the upswings have been longer, as the Federal Reserve has used unprecedented measures to
extend up cycles in the economy and the financial markets. But in spite of the Fed’s best
efforts to control economic outcomes, the natural cycles of boom and bust in stocks, or
growth followed by recession in the economy, eventually win out.

After five years of generally rising stock prices, there are plenty of signs that this bull
market is tired. One trend that often repeats in the late stages of bull markets is investor
money moving toward companies with very uncertain prospects. It seems paradoxical,
but near the end of a long market run investors become enamored with sketchy companies,
while they take profits on the companies that have been leaders of the market advance.
Because most stocks are highly priced after a long upturn in the market, investors are
tempted to reach for something different, a stock that has not been part of the rally. Such
companies are either new to the marketplace, or are older companies that have been trailing
the market rally. Investors seem to sense that the party is winding down and it’s time to go,
but they want to find one more partner for a final dance. Investment banks fulfill that desire
through initial public offerings (IPO’s) of stock in highly speculative, concept companies.
The recent surge in IPO’s, a big increase in mergers and acquisitions, and a rise in longtime
market laggards, are signs that it is late in the rally.

By observing markets for many decades, we have become aware of certain patterns
that accompany inflection points in bull and bear markets. While there are broad similarities
or patterns, each bull or bear market has some characteristics that make it unique. The
collapse of 2008-2009 was marked by the bankruptcy, forced merger, or virtual
nationalization of many large financial institutions, which made that bear market different
and worse than most. The patterns that do seem to frequently repeat have to do with the
type of stocks that lead in the early stages of a market rally and the ones that rise later, near
the peak of a market move.

In the early stage of a bull market the leading stock gainers are often the companies that
prospered during the preceding bear market, and companies in highly cyclical industries. In
the later stages of a bull market, as stocks that have led the advance start to fade, investors
shift their attention and funds to concept stock IPO’s, takeover candidates, and former market
laggards. We are seeing that trend unfold now, as the stocks that have led the bull market for
years have been universally pounded in recent months, while former laggards have garnered
favor with investors. When stocks that have led the bull market start to collapse, and the
laggards take over market leadership, it is a clear warning sign for investors. While the
“pieces of the puzzle” that indicate a market top are falling into place one by one, forming
a final top can be a long, drawn out process.

Current Strategy

The U.S. stock market was basically flat for the first quarter of 2014, following a robust
gain in the previous year. The market dipped and rallied on several occasions during the
winter months as tensions in the Ukraine kept investors on edge. Sharp declines of twenty
five percent and more on most of the leading, momentum stocks further chilled investor
psychology. After a virtually uninterrupted rise in stock prices during 2013, investors
rediscovered that large, quick losses are possible if one pays too much for a popular stock.
There was an echo of the bubble of 2000, as the social media and biotech stocks
hit a sudden air pocket and dropped altitude quickly. The major market averages held up
in spite of the severe declines in the leading momentum names, because investors shifted
money to other sectors.

We welcomed the increased volatility as the price movement brought a few more stocks
into either our sell or buy range. Even though a higher market carries more risk and less
reward on an overall basis, opportunities can develop that do not correlate with the market
averages. With the recent, sharp decline in a large number of higher quality companies,
we have made a few new purchases that we think will do well on a long-term basis.

It was a quiet quarter in the fixed income market. Last year we added treasuries and
municipal bonds to accounts after rates rose rapidly from 1.5 to 3 percent on ten-year
maturities. In the first quarter of 2014, the rate on the ten-year treasury backed off to 2.6
percent, as the Ukrainian crisis and sharp declines in momentum stocks drove nervous
investors into risk-averse assets. We intend to start buying fixed income paper again, if
and when fears subside, and rates rise to 3 percent or higher.


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