An anatomy of the Stock Market! - Bull & Bear Market Cycles

An anatomy of the Stock Market! - Bull & Bear Market Cycles

In financial markets, the “majority is always wrong.” When the investing majority or the crowd is overly bearish, this is the best time to be buying stocks. When the crowd is overly exuberant, this is the time to be selling stocks. The financial markets work in this ironic way because not everyone can win in the market.

The Start of a Bull Market

The bottom of the market starts at a time when the stock market is weak and the general population is pessimistic. At this point most investors sell after having endured a long and torturous bear market. This extreme pessimism found at a bottom is always irrational and undeserved. Now the market is undervalued and is a bargain. Savvy investors, the “smart money”, buy bargain stocks knowing that they will be able to sell them higher in the near future. Smart money buying, called accumulation, causes stocks to rise.

The smart money often consists of operators, and corporate insiders (promoters of companies). These traders have access to information that the general public does not.

Rising stocks eventually gain the respect of institutional investors, as billions of dollars of capital is introduced into the market place. Mutual fund investment causes the stock market to advance in a powerful manner. Much of the steady large trends are powered by institutional investors. After the stock market has gained, stocks are now fairly valued and are no longer considered bargains. The smart money is now sitting on a large profit, as well. The average investor is still skeptical, however.

As bull market events unfold, retail investors begin to take interest in stocks. Retail investors, or the unsophisticated little guy, make up the vast majority of investors. This group does not invest for a living. Retail investors often make investment decisions based on what they read in financial magazines, from their brokers and from tips from friends. As the flood of retail capital is invested, the market soars, causing great euphoria. At this point in the cycle, many companies become public, or launch an IPO. Companies go public when investor sentiment is most optimistic so as to gain the highest possible stock price. IPO’s generate even more optimism as unsophisticated investors buy into the fallacious thoughts of instant riches. Now is the time when many small investors become wealthy. In this phase, stocks are doubling and tripling as the media cheers on the advancing bull market.

At this point, the smart money sells, or distributes, the now overvalued stocks to overconfident retail investors. The smart money knows that overvalued stocks are no longer worthy investments, and will soon drop in value. Widespread greed always occurs, in some form, at stock market tops. Sometimes this greed takes form as stock market scams and fraud. These immoral activities can take place because irrational retail investors will buy a stock simply because it is glamorous. To compound the problems, investors will now start to use margin, or leverage, to further accelerate gains. All caution is thrown to the wind as investors think “the old rules don’t apply”.

The Start of a Bear Market

After mutual funds and retail investors are fully invested, the market is overbought. This means that there is no more cash to fuel the rally. The market can only go in one direction: down. All it takes is just a hint of negative news and the market collapses under its own weight. Investors quickly realize the market is made of smoke and mirrors, as frauds or other scams come to light.

When panic selling starts, a market will always fall quicker than it had risen. Oftentimes, as everyone heads for the exit at the same time, there isn’t anyone willing to buy the stock. This can be especially disastrous for margin users as they grow deeply indebted to their brokers. Bankruptcy is the usual result for these foolish gamblers. The majority of retail investors don’t sell even as the market is plummeting. This crowd keeps holding on to stocks in hopes that the market will recover. As the market plummets 25%, then 50% the average retail investor foolishly holds on, in complete denial that the bull market is over. Finally retail investors sell every stock they own plummeting the market even further. This mass exodus is called capitulation.

The Cycle Starts Again

It is at this point that stocks are undervalued once again. The smart money is accumulating and stocks rise. The majority of retail investors bought at the top and sold at the very bottom. This is the very essence of the “dumb money”. They are perpetually late into the game. This cycle continues over and over. Only the smart money actually “buys low and sells high”. After trading in this manner, the dumb money will adhere to adages such as, “the stock market is risky”. In reality, however, the stock market is only risky if you trade like the mindless majority!

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Best Wishes!

Traderji

www.Traderji.com

Traderji, wonderful write up. Gained a lot. I suggest everyone should read this.

Thanks,
nkpanjiyar

Great write-up......Thanx Traderji!

Very good article. Every trader shold remember this before entering the market.
gvnarendra

Dear Traderji
Fantastic write up!!. Hope we all learn from this and try to become part of the "smart money".

Excellent post, Traderji and wonderful sequencing. You really live up to the trend of explaining basics exceptionally well and you time them well too.

Only thing is that a majority of people in this forum would also be in the :”unsophisticated little guy” as Professional investors/traders in India is a rare breed which perhaps forums like these shall help create
How does one know that the market is topping. Though I am no expert, these are my observations(nifty/sensex):-

1) Monthly charts at all time high
2) Momentum indicators in weekly charts showing overbought levels or prices falling below 30 week average
3) Prices falling below the 200 day moving average or below the two-thirds fibonnacci retracement of the primary market trend
I don’t know how much fibonacci applies to weekly charts in this respect

Following the ripple, wave, tide syndrome, you probably identify the tide change by looking at the monthly/weekly charts and look for intraday turnarounds beginning with looking for bearish reversal patternos on 30 min charts?
I should add that When the market peaks and one wants to sell, one can apply a 20day moving average as a trailing stop loss.?

One can always get further intellectual satisfaction by tracking US interest rates, FII and mutual activity etc.

For identifying market bottoms, it would be reverse of the above. I have always been fascinated by how investors use technical analysis and traderji has come with a really good post. However unless we have specific and correct pinpointed information, such posts cannot stop trailing losses to us small,little,tiny investors. Its David v/s Goliath and you gotta support the underdog.

I am not much of an expert at all this and so any corrections would be as welcome as corrections to primary trends are to detect a new trend. Weekly specifications of stochastics/RSI and others applicable also would be appreciated.

Come to think of it, I have not seen any monthly chart attachment on any of the posts and weekly chart also comes in once in a blue moon. Anybody wants to criticize what I have written or contribute anything on Techincal analysis for investing, please do so. Sometimes, TA seems better at timing investment profits then following the short term hocus pocus. However TA itself is a conglomerate of indicators and so the more precise and clear the info, the better. Lets create a new trend for the small guy. If we create understanding, the small guy will no longer remain a puppy between the bulls and the bears.

Smallguys may or may not have metastock but those who do can try the negative and positive voulme index for showing smart money affiliation. File pn2.doc attached. Comments welcome

Attached Files

pn2.doc (19.5 KB, 332 views)

The basic issue is identifiying a bull or a bear mkt. Extracts from Willam Eng 's trading rule book:-

This explains the two- thirds fibonacci

Elsewhere in the book, the author has explained in little more detail what traderji has explained above. He says there are three categories of stocks-primary, secondary, tertiary. When the mkt bottoms out, savvy investors first pick up the primary stocks or blue chips as a sign of revival. They being blue chips, others cannot afford at the end of bear cycle. Then after a while they dump them to others and switch to secondary stocks and when both peak they sell both and sit pretty waiting for the market to bottom again. There too the primary stocks are the last to fall and when they begin falling it can be a sign of doomsday.The five wave Elliot wave theory probably explains this phenomenan but unfortunately the wave count is too bloody confusing.I know that profits are made mostly in the third and fifth impulse waves. I think at the end of the first impulse wave, primary issues peak, third impulse wave-primary/secondary issues peak and fifth impulse wave- all peak and the market tops. This is my guess but if some enlightened person from among you can illuminate this phenomenan, that would be the height of illumination/elnightenment.Otherwise it would be the mother of all confusions which we can do without since we already have the mkt.

Us little guys unfortunately try to get in at every tom, dick and harry stock(in all the three categories)are at a peak and get rodgered in the process unless we are lucky.

This need not apply to everyone depending upon luck and competence. My father has been a succesful investor for over 40 years and does not give a damn to technicals or cycles.

However, everybody cannot have natural talent and all this information is useful. So focus my dear friends is " How to indentify bear/bull cycles". It is said in this context that it is better to be vaguely right rather than exactly wrong. All comments welcome.

Great piece of information. Thanks a lot Traderji. I shall follow your advice.

One of the most ROBUST & RELIABLE WAY to identify BULL & BEAR Markets are as follows:

A BULL MARKET can be defined when the major Indices (BSE SENSEX, NSE NIFTY, etc) form a series of rising peaks and rising troughs (higher highs and higher lows) in the WEEKLY CHARTS.

A BEAR MARKET can be identified when the major Indices (BSE SENSEX, NSE NIFTY, etc) form a series of declining peaks and declining troughs (lower highs and lower lows) in the WEEKLY CHARTS.

__________________
Best Wishes!

Traderji

www.Traderji.com

That is fine and can be seen in daily charts in detail but the most important thing also is when do they end and the other begins. Since you have mentioned weekly cycles, I would presume that on the weekly charts,the price hit previous significant bottom once or twice, could this be taken as the beginning of a bull cycle. On the daily charts it would be two-thirds retracement.

Actually in books all this is not given clear cut maybe because it is not easy to pinpoint.

I thought that beginners could fool around with Elliot for the major trends at least. Trying to find the minor waves/subcycles can be as perplexing as the mkt. Does Elliot does not have a role in this context? Thanks for the info and the post.