We have talked at length about how prices tend to move between a band around its intrinsic value.  At times like these it almost feels like there is no method to this madness.  But why does it happen?

When prices begin to rise from the bottom they are singularly driven by fundamental considerations or its intrinsic value.  Once it picks up some momentum (typically on good quarterly performance) some traders jump on the band-wagaon driving up the price which in turn attracts others who follow price trends.  This, as you can see, creates a self fulfilling dynamic.  If on top of this there is broader good news or indexes moving up (sentiment) then this price fervor spreads to other stocks.  The thinking is that if the best of breed stock is doing so well then most of the stocks in that industry will as well.  Also if the economy is on a tare then all stocks can only go up!  At some point stocks begin to trade at unsustainable multiples.  Analyst, who’s fundmantal models are indicating over-bought positions, quickly switch to forecast earnings instead of historic averages to justify the ever expanding multiples. 

At the peak, the sentiment is so bouyant that investors adopt the ‘greater fool theory’ – if I bought at X, surely someone would buy it from me at X+delta.  At these times, investors are beginning to doubt their own optimism.  Then the inflection happens – historically, in some unrelated market like the japanese bond; rates increase causing a steep drop in cheap funds which made hedge funds liquidate good positions in any market they had them in.  From here on the unassailability of stock prices is broken and a cycle of conviction testing begins.  Investors begin to ask – ‘I bought because the prices were going up, but if that is not the case anymore should I still be holding them?’.  Small cap, poor fundmental stocks are hit first.  This is where smart money begins to unwind its position.  The price-shock, however, is not the severest so the individual who bought at high levels holds on in the hope that the markets will come back.  It often does, breaking its earlier highs because some investors find these lower prices to be a steal compared to what they paid just weeks before – remember we are still using forecast earnings!  These price rises happen on lower volumes.

The myth is broken - there is now underlying doubt.  Investors begin to get defensive on additional purchases.  At this point prices become vulnerable to sharp corrections.  A trigger like Dow losing 500 points will be enough to reinforce simmering doubts and the first stage of sell–off begins.  Investors who are purely price focused, exit – these are hedge funds and other speculative vehicles creating an intermediate bottom.  If short selling is allowed these entities will reverse their positions putting further pressure on price.  At this point there is serious introspection and fundamentals come back into the vocabulary.  Investors still hope that this is the bottom and hold on.  Then comes a shocking news – a large institution going bust. It is a race to the bottom from here!  Prices keep falling till everyone who has a doubt or has reached his pain threshold has exited.

At this point, stocks become over-sold and panic prevails.  This is signalled by analysts lowering the their estimates, which is nothing more than switching back to historic averages.  After a period when investors have gathered their nerves, typically coinciding with some fiscal/monetary policy stimulus – smart money begins to very slowly hunt for bargains amonst the best fundamental stocks.  Prices remain range bound for some time as people still remember the wealth destruction of the last cylce.  Six to nine months  and some good macro and/or corporate performance news later, capital begins to flow more freely, especially, international funds which creates a micro-rally in core stocks.  And the cycle begins anew!

 

 

This is the identical script for every cycle.  Change Lehman to LTCM and you would not know which cycle you are talking about.  This is why serious investors are ones who have seen this cycle play-out at least once.  What is amazing is the regularity of the cycle and how little we learn from it.  As individual investors, we enter the market only when we hear how our friends are making a killing in the market.  This is typically the market peak.  We enter counters that we are told has made tremendous money and will keep doing so – story stocks.  Since we entered the stocks on mere hope, we hold on to it even when the prices go down, till the pain overpowers the ego of having bought without having a clue of what we bought.  This is typically the bottom – the final capitulation.  In effect, the individual investor bought high and sold low.  This is neither new nor shocking – it happens each and every time with clockwork precision. Think about the script, have you seen it before?  What is it that logically, you should be doing now?