The following progression serves to sum up regarding the upswing of the market cycle. It shows how cycles in economics, profits, psychology, risk aversion and media behavior combine to move market prices well beyond intrinsic value, and how one development contributes to the next.
- The economy is growing, and the economic reports are positive.
- Corporate earnings are rising and beating expectations.
- The media carry only good news.
- Securities markets strengthen.
- Investors grow increasingly confident and optimistic.
- Risk is perceived as being scarce and benign.
- Investors think of risk-bearing as a sure route to profit.
- Greed motivates behavior.
- Demand for investment opportunities exceeds supply.
- Asset prices rise beyond intrinsic value.
- Capital markets are wide open, making it easy to raise money or roll over debt.
- Defaults are few.
- Skepticism is low and faith is high, meaning risky deals can be done.
- No one can imagine things going wrong. No favorable development seems improbable.
- Everyone assumes things will get better forever.
- Investors ignore the possibility of loss and worry only about missing opportunities,
- No one can think of a reason to sell, and no one is forced to sell.
- Buyers outnumber sellers.
- Investors would be happy to buy if the market dips.
- Prices reach new highs.
- Media celebrate this exciting event.
- Investors become euphoric and carefree.
- Security holders marvel at their own intelligence; perhaps they buy more.
- Those who’ve remained on the sidelines feel remorse; thus they capitulate and buy.
- Prospective returns are low (or negative).
- Risk is high.
- Investors should forget about missing opportunity and worry only about losing money.
- This is the time for caution!
The most important thing to note is that maximum psychology, maximum availability of credit, maximum price, minimum potential return and maximum risk all are reached at the same time, and usually these extremes coincide with the last paroxysm of buying.
Likewise, the following progression outlines what happens in a market downswing.
- The economy is slowing; reports are negative.
- Corporate earnings are flat or declining, and falling short of projections.
- Media report only bad news.
- Securities markets weaken.
- Investors become worried and depressed.
- Risk is seen as being everywhere.
- Investors see risk-bearing as nothing but a way to lose money.
- Fear dominates investor psychology.
- Demand for securities falls short of supply.
- Asset prices fall below intrinsic value.
- Capital markets slam shut, making it hard to issue securities or refinance debt.
- Defaults soar.
- Skepticism is high and faith is low, meaning only safe deals can be done, or maybe none at all.
- No one considers improvement possible. No outcome seems too negative to happen.
- Everyone assumes things will get worse forever.
- Investors ignore the possibility of missing opportunity and worry only about losing money.
- No one can think of a reason to buy.
- Sellers outnumber buyers.
- “Don’t try to catch a falling knife” takes the place of “buy the dips.”
- Prices reach new lows.
- The media fixate on this depressing trend.
- Investors become depressed and panicked.
- Security holders feel dumb and disillusioned. They realize they didn’t really understand the reasons behind the investments they made.
- Those who abstained from buying (or who sold) feel validated and are celebrated for their brilliance.
- Those who held give up and sell at depressed prices, adding further to the downward spiral.
- Implied prospective returns are sky-high.
- Risk is low.
- Investors should forget about the risk of losing money and worry only about missing opportunity.