The bull market will end, but not yet
by Raul Elizalde - 2014-09-03
Risk assets, and especially US stocks, have enjoyed a virtually uninterrupted rally since the dismal days of 2009. But fatigue is settling in.
After five years of increasing prices, investors are finding it hard to believe that this bull market will continue, and many fear that a correction is imminent. Some analysts even predict a catastrophic 50%-60% decline. But if today’s bull market turns out to be like past ones, stocks could keep climbing a lot more.
Capitalizing on that potential, however, will not be easy. It will require that investors find a way to control the damage caused by occasional market retracements that will be inevitable on the way up.
It is true that the market has gone up without a significant correction for a long time, but this is by no means unprecedented. Huge bull markets happened in the wake of serious past crises, with stocks reaching levels that were unimaginable at the time.
For example, the US stock market fell hard in the years leading up to the US involvement in World War II. But after touching bottom in 1942, the Dow Jones Industrial Average (DJIA) climbed an astounding 1,000% in 24 years.
An even more dramatic rally took place after the stagflation of the late 70s and early 80s, and accelerated after the crash of 1987 – a harrowing event which remains to this day the largest one-day fall of the US stock market. In just thirteen years, stocks surged 700%.
Comparing today’s rally with those mega-climbs shows that the upside could be huge.
There are two important caveats. First, it is impossible to know whether a secular bull market is under way. The underlying forces that could propel stocks to such heights can only be clear in hindsight, because it would require a lucky navigation around the many risks that are present today. A rapidly evolving spat between Russia and the West, deflationary forces in Europe, and a new and destabilizing role of China in the world balance of power are only some of the elements that can take asset prices into any given direction.
And, second, even if the DJIA can surge from its current 17,000 to a level comparable to those bull markets – maybe as high as 50,000 or 60,000 – the road there is bound to be littered with money-losing intervals. For example, stocks fell more than 8% from a previous peak about 9 times in the 1987-2000 bull market, and more than 15% twice. The 1942-1966 bull market was equally volatile, falling twelve times more than 8%, and five times more than 15%.
While a hypothetical buy-and-hold, volatility-oblivious investor would have reaped enormous gains by the time those bull markets were over, normal investors are unlikely to hold on to their positions through periods of upheaval.
This is not, as behaviorists usually imply, a flaw of human nature. It is simply because it is impossible to know in advance whether, say, a 15% market decline is just a temporary blip that should be ignored or the beginning of a much larger fall. In the eighteen years between 1965 and 1982, for example, a 15% fall was followed by much deeper losses many times. Holding on to a losing portfolio was not rewarded.
Current observers who claim that the stock market is overstretched only because it has gone up too much since the financial crisis should take another look at history. If a secular bull market is truly under way, the upside can be huge.
But investors should still be mindful of the risks inherent in the stock market. Realizing potential gains will not only require a great deal of luck but a way of smoothing out the inevitable corrections that will take place in the intervening period. Without a way of controlling the downside, investors will find it hard to realize any gains, no matter how large they could potentially be.
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