As the end of the upmove looms, the market runs up the final mile on the left-hand side of the hill.
THE higher the market goes, the smarter the optimists appear. The longer the market runs, the greater the social, financial, economic, and political pressure to conform to it, to believe in the market, and belong to it. It’s a monstrous, dominating force.
In normal times, if you don’t play the game, you neither win nor lose. In boom times, if you don’t play, you lose automatically. Risk is not losing money — it’s missing the elevator. If you’re skeptical, vocal cheerleaders with no experience or knowledge of market history will scold you.
The contrarian is silenced
Thus skeptics learn to keep quiet — for three reasons. First, the market always runs higher and longer than even wild-eyed optimists can imagine, let alone what the pessimists predicted.
What registers in the stock market’s fluctuations are not the events themselves but the human reaction to these events, how millions of individual men and women feel these happenings may affect the future. Above all else, in other words, the stock market is people.
The huge advances that come after public warnings prove doubters and cynics resoundingly, thoroughly wrong. After these humiliations, outspoken critics lose their audience and no longer warn of excessive valuation. As for the real bear, he quietly closes his short positions and picks up another shift at the gas station.
Second, the naysayer’s logical and detailed argument is no match for the magical thinking of the average investor. Indeed, the trademark of the top is the widespread belief that the emperor is fully clothed. You hear the word. Stocks produce the best returns. Real estate is safe. Gold protects you. China changes everything. Self-evident truths like these counter any argument. Because the investment is so solid, the critic must be wrong.
Third, anyone who listened to the discouraging words of the pessimists and actually reduced or sold their position is angry. These know-it-alls cost him a fortune. He’ll never listen to them again. Now he’ll either wait for a chance to buy back in, or sit the market out, or reload near the top. Whichever way he addresses it, he’ll likely never sell again. Now he’s resistant to selling, like he’s had a vaccination.
Caution is so counterproductive. As year follows prodigious year, you hear the distinctive sound of towels thrown in. The crowd noise becomes noticeable. In the last months, non-believers question their non-belief. After all, if you think everyone is crazy, you must be the crazy one.
Even experts see no reason this upward trend will stop. In fact, it will continue indefinitely. Such is the power of a topping market to suck in the last buyers and crown the greatest fools.
The money manager stampede
As the market approaches its zenith, irresistible forces take over the minds of circumspect money managers and turn them into stampeding cattle. The primary force is money seeking maximum return in the shortest possible time. Its mission is to hunt for the hottest money managers and flow into its targets.
Money managers love the flow, when it’s on the way in. But if the managers don’t keep up the pace, the flow goes the other way, and then the managers lose assets — and probably their jobs. What really hurts is how investors compare a manager’s results against the froth. Even if you’re up 75 percent, if the froth is up 100 percent, you’re a bum.
As the top approaches, investors descend the quality ladder, rolling profits into the next thing, going from good idea to bad idea, from original to copy cat. Many of these later investments are doomed, future victims of market saturation and overcapitalization. But the average investor is undeterred. For now, he’s going with what’s working. He’s never heard of Templeton’s point of maximum optimism, and no one is about to tell him.
Cause of death: starvation
Exactly when it is least expected, the market reaches the top. From here, everything happens on the right-hand of the hill. Some say the top happens because conditions at their best can only get worse. While that sounds reasonable, it’s only partly true, because conditions at the top are not really at their best.
Judging by market internals like new highs and advances over declines, the stock market has been weakening for months. A shrinking number of stocks has carried the ball forward.
Also, all that merging, acquiring, and other deal making may have lifted stock prices, but the resulting debt burden weakened bondholders, and pressured management to lay off staff, cheapen their wares, and defer major projects.
Investors for their part have developed debt service problems of their own, and are cutting back. The dead weight of interest expense pulls on them. The system is overripe.
But immediately prior to the market top, the atmosphere does not smell of danger. Expectations are rosy, if not grossly overconfident. Sellers are reluctant. The market ignores bad news. Something else causes the market to stop rising and start falling.
We know that asset price inflation requires a constant inflow of capital. Without fresh money, asset prices cannot inflate. Recall the real estate industry’s hand wringing over first-time buyers, or the dotcom concern for burn rate, or private equity’s addiction to debt. The system needs new blood to grow.
Still, even with easy credit to bring in the buying, prices cannot rise indefinitely. Eventually the last flight attendant will buy.
But inflows are only part of the story. Buying pressure may inflate prices, but intrinsic values stay the same. Those are the values derived from newly obsolete fundamentals, like free cash flow. To a trend follower, rising prices today suggest rising prices tomorrow. To the fundamentalist, rising prices today reduce expected returns to the horizon.
And so the top is made, one part constriction of capital flow — running out of full-price buyers — and one part the law of diminishing returns, when it’s pointless to invest.
Tops are the bane
of all investing.
There might be a specific detonator. There might not. It could be a spike in interest rates that messes with people’s discount models. Perhaps an uptick in defaults stems the frantic lending. Somehow the gap between expectations and reality makes itself obvious. Overnight, perception changes, and prices start to fall.
The chart below shows five distinguished tops, each one drawn to the same scale over a two-year period, with the top at 100. Looking at these tops, you may see that they look somewhat alike. Price action seems patterned.
The typical top starts with a sell-off of varying severity. Following this downmove, a substantial rally ensues, often lasting several months. This rally runs on residual confidence and misplaced hope that the worst is over.
Following this second chance to sell, which so resembles a recovery that few investors do sell, a panicky slide begins. This downmove is usually a convincer, a steep descent that scares investors and presages the dramatic tumble into the basement yet to come.
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