The Four Phases of a Bull Market

The Four Phases of a Bull Market

Sir John Templeton, who was given the tag of "arguably the greatest global stock picker of the (twentieth)century”, founded the Templeton Growth Fund in 1954. He famously said, "Bull markets are born on pessimism, grown on scepticism, mature on optimism, and die on euphoria."

While many experts have even further subdivided the phases, I think Sir Templeton's prognosis is a simple template for analysing the bull markets. This categorisation may be a bit simplistic as all bull markets have their own nuances and differences but I feel it is still very effective. Let us first look at what each of these phases typically look like.

The Pessimism Phase
This phase typically comes at the end of a big downtrend, when everything is seemingly at its worst and while the news-flow is still bad but the market stops reacting to bad news. This is a very difficult phase to enter as in general there is still a lot of gloom. However, smart investors start to enter the market in this phase. The asset based valuation metrics like Price/Book or measures like Dividend Yield work well in this phase. The Trend following technical analysts are still very bearish as typically this could be a sideways market. The one big exception here was the almost V shaped bounce in the market following the Financial crisis in 2009 when most investors remained very bearish.

Market disillusionment characterizes phase one of a bull market, according to Futures Magazine. This "reluctance" phase follows a bear, or falling, market in which many sold their holdings to cut their losses. The general public has little confidence in the market even though average prices and price/earnings ratios are typically low. Institutional investors start to accumulate holdings to take advantage of the low prices.

The Scepticism Phase
You would have heard in the press or some experts saying that the market is climbing the Wall of Worry. They are talking about the Sceptisicm phase. In this phase while the news stops being negative but investors in general are still not convinced about the market. Market participants look at earnings based measures like P/E or EV/EBIDTA and buy them only when they look attractive. The short term technical trends become positive but the tendency is to trade as the volatility is still high.

Individual investors begin to return in the second phase of the bull market. Institutional trader, Ali Meshkati, notes that, as they recognize the potential for a bull market to develop, investors study stocks in earnest once again. Stock prices, having increased for several months, attract more interest. In this second stage, investors add to their portfolios, which pushes prices higher. Rising prices create demand and greed sets in.

The Optimism Phase
During this phase, negative sentiment starts to reduce and typically the economic outlook starts improving and news-flow becomes positive. This phase can be long lasting, and also sees a broader participation of investors and of stocks. The trend following technical analysts do very well. Volatility comes down and buying on dips becomes a very profitable and easy to follow strategy. Investors start justifying valuation through measures like PE to Growth, Relative valuations, Sum of parts as the bull market matures.

Chris Johnson writes in his Winning Edge investment newsletter that this acceptance phase is the most powerful bull market. Stock prices soar as new investors enter the market. IPOs become popular to take advantage of growing public interest in investments, while the number of corporate mergers and acquisitions, fed by the availability of capital, increases. Media coverage gives investors pointers on how to profit from market activity. Institutional investors sell the shares they bought in phase one, then move into technology and other more speculative stocks. Mutual funds benefit from investors shunning cash vehicles such as money market funds, a reflection of confidence in sustained market growth.

The Euphoria Phase
In this phase money making becomes very easy. The perception is that only good things lie ahead. This is also usually the phase when investors who were sitting on the sidelines all this while start entering the market. Number of IPO's announced sky-rockets, stocks of companies considered untouchable do very well. New valuation metrics are often created for example towards the end of the tech boom in 1999 we saw market values of internet companies being justified based on the “eyeballs” they attracted on their site!

This "exuberance" phase is a period of volatility, high trading volume and high expectations. Investors in this stage of a bull market become speculators who ignore fundamental performance measurements when choosing stocks. An overriding feeling that the market will continue to flourish prevails. However, the market eventually becomes crowded, leaving fewer new investors. The flow of dollars sustaining market performance begins to trickle and top-performing stocks start to drop. The bubble of this final stage bursts as investors realize the market has outpriced itself.
This is the “melt-up” phase , Here, the ferocity of fall in the market after this phase is directly related to the ferocity of the rise!

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