Why a Bull Market Ends

Jon writes about this on his blog. When? That’s what everyone wants to know. The answers to why a bull market ends come pouring in the second the when is confirmed. But the explanations why are usually complex. They certainly won’t help anyone predict the next turn. They’re often secondary, or scapegoats, to what really happened.

Peter Bernstein offered a simple answer to what triggers the end of all bull markets: What was the secret ingredient that kept investors buying and buying at higher and higher prices? Was it the myths that this market, like all bull markets, created to justify itself? Although the myths helped keep the pot boiling, the basic explanation for the bull market’s longevity and vitality in the face of so much economic difficulty is simpler, more fundamental, and more easily generalized. The same simple, fundamental explanation applies to the bull market’s sorry end as well.

The common thread that runs through all equity bull markets is confident expectations of higher earnings ahead. The common thread that ties the onset of all bear markets together is the loss of those confident expectations of higher earnings ahead. History shows us, over and over, that bull markets can go well beyond rational valuation levels as long as the outlook for future earnings is positive.

Bull markets require economic slack so that companies can grow, and positive trends in real business activity to take advantage of that slack. Remember, stock prices show no consistent relationship with interest rates, exchange rates, inflation rates, budget policy, monetary policy, or any of the other things professionals love to discuss. These forces matter only when they matter to the future movement of corporate earnings. Those same irrational valuations that seem to defy gravity spur the “myths” that get investors into trouble. The big mistakes — overconfidence, trivializing risk, chasing returns — can leave investors under-protected for what inevitably comes next. Overpaying for (optimistic) future earnings never ends well.

Jon concludes that the important thing is to recognize the role confidence has on market prices and the obvious risk of getting caught up in the excitement.