This post is from staff writer Richard Barrington.
Have you got bull market fever yet?
Its symptoms are giddiness and a blurring of reality. It happens when the stock market has had such a run of success that investors start to imagine just what kind of riches it would create if that run just kept going.
You can tell bull market fever is going around by the sheer volume of commentators offering theories on why the market is poised to go onward and upward. These are the same voices that were prevalent in the summer of 1987, then again in 1999, and again in 2007.
We all know what happens next. The expert commentators always manage to survive these setbacks — they simply shrug it off and move on to selling their next prediction. The real devastation comes to those normally cautious investors who get lured into taking more risk than they should at precisely the wrong time. Those are the people who need to avoid catching bull market fever.
Now, let’s be clear. I am not predicting the next great bear market. I’m just saying there’s starting to be an awful lot of bull in all the current bull market talk. If you don’t want to get burned, here are six things to watch out for:
- This time, it’s different. It’s not that bull markets are created without a rationale — there is generally a convincing-sounding reason why success should not be limited by the normal boundaries this time around. This can be applied to why an individual company should be able to keep expanding beyond its normal saturation rate, or why conventional valuation parameters for the market as a whole should no longer limit the price of stocks. The truth is, it’s always different — no two bull markets play out exactly the same way. For that matter, neither do any two bear markets. Despite the differences unique to each situation, just remember that the fundamental rules of business and economics still apply.
- Trust in momentum. One of the most striking symptoms of bull market fever is how much trust people come to place in sheer momentum. This is the believe that a stock’s earnings will grow at 20 percent this year because they grew at 20 percent last year, or that stock prices will go up by 15 percent this year because that’s what they did the year before. With stocks, it’s not the case that what goes up must always come down, but even in the best case scenarios growth rates have to level off.
- Earnings gains through cost cutting. A recent example is HSBC bank, which has already cut $4 billion in costs and is looking to lop off another $3 billion. This has shored up earnings enough for the stock to outperform its sector over the past couple years. Sometimes cost-cutting is necessary, but only as a temporary, corrective tactic. Serial cost cutting is not a strategy for long-term growth, so if that’s the only way a company is improving its earnings, don’t bet much on its future.
- Story stocks. These are the companies with compelling-sounding concepts behind them. Often they involve the next great franchise, or the next big thing in technology. It’s bad enough that those stories are often better than the actual product the company offers, but even when there is something real behind the story, these stocks are prone to be overpriced. Remember, you aren’t the only one who has heard the story, so keep in mind what that may have done to the stock’s price.
- Asset bubbles. These are things investors pile into just because other investors are piling into them. Gold was one until recently, and before that, real estate. If you feel tempted to get into an investment just because that’s where it seems the crowd is going, be aware that you may be buying into a classic asset bubble.
- The interest rate contradiction. This is a particular oddity of the current situation. The stock market has been rising lately on optimism about the economy. Beyond that, stock prices have been driven up in recent years because interest rates are extraordinarily low. The Federal Reserve has made it clear that it will back away from its low interest rate policies once the economy improves, yet the market has been a little skittish whenever there have been hints that the Fed might allow interest rates to rise. In short, the market seems to want both economic improvement and a continuation of record low interest rates, but the two are somewhat contradictory. If valuations are based on optimistic earnings projections but what are essentially pessimistic interest rate levels, one part of this calculation won’t work out.
Don’t get me wrong. I’m actually mildly optimistic about the economy itself. As for the stock market though, it seems to have over-anticipated the good news, leaving relatively little more to gain and a great deal to lose if the economy disappoints.