Is This the Bottom--Update #4
With the market indices reaching near-term highs on the strength of continuous daily gains, I feel the need to update the discussion on the process of completing a down cycle in the stock market.
In the later stages of a down market cycle, the market will tend to overshoot on the upside, just as it tended to overshoot on the downside. The challenge is that while there is a sign of recovery, much of the data hasn’t confirmed it and market participants will experience a bull market life cycle in a short-term window.
Those that are early predictors of market recovery will be the first in and will bid up the market causing mid-stage adopters to join in the market and buy the market higher. Volumes will tend to be reduced because market participants will have decided to either get out because it is too painful or to hold on because it is too painful. The low volumes combined with a large number of market participants now wanting to get into the market will cause a short-term over-bought condition in the market that can last for several months and can be significant in percentage terms.
The more important challenge for market participants occurs as the data coming from critical measures of economic activity continue to be inconclusive or “lumpy”. Some data may show improvement while other data will show further declines—in fact, some data my look great one month and terrible the next. While the market will predict the recovery six to nine months in advance—the market has seemingly predicted twelve of the last three recoveries. In other words, the market as a short-term forecaster is not particularly accurate.
The mixture of positive data with patches of negative data and large sets of neutral data make for a volatile market. The combination of market participants wanting to get back into the market, low relative market volumes and mixed signals from the economic data confirms and exaggerates market volatility.
For example, if the market believes that the economy is recovering quickly, the market may increase by a significant percent in a continuous set of daily gains. However, this is not necessarily an indication that the economy has recovered and the market is at risk of giving back those gains if new data does not confirm the recovery.
While strong recoveries sometimes follow deep recessions; historically, recoveries following financial crises have been slower and more painful recoveries. As history would suggest, we are now working through a significant financial crisis which would indicate that the recovery would be slow and painful with data that is lumpy and inconclusive.
A normal market response to this financial crisis recovery with inconclusive data would tend to be unusually volatile in the short-term and less profitable in the long-term. If this is indeed the case, the market will likely offer a less-volatile, abnormally profitable investment opportunity at some point in the future—but not today.
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