As 2017 drew to a close and 2018 rolled in there were a lot of analysts and Wall Street experts pontificating as to where the markets would go in the next year. For the most part, the sentiment has been generally bullish with no real reason to question the market’s move up. Fundamentals are strong, unemployment is low, and times are good from an economic perspective.
With all the good news about the economy it’s hard to reckon with the overwhelming fear that I hear when speaking to many investors. Many investors that I speak to have this feeling in their gut that eventually the rug is going to get pulled out from underneath them and there’s going to be another financial collapse. So which is right? If we look at the Historical picture of a bubble both can be right, and it can lead to a melt-up followed by a melt-down.
What in the world is a melt-up? To truly understand that, it is important to understand how traditional bubbles work. There are traditionally four stages in a bubble.
The first phase, known as the Stealth Phase, is characterized by “smart money” getting into a market and generally keeping quiet about it. When too many people start piling into the investment, the prices can soar out of control too early. When prices soar too early it makes it difficult for the “smart money” to make the profit that they want; so they typically will remain quiet about the investment opportunity until it eventually moves into the second phase: the Awareness Phase.
The Awareness Phase is where institutional investors start accumulating and adding to positions; this is typically also characterized with an initial sell-off that shakes out many early individual investors. This shake off is often known as the “bear trap”, because it traps some of the bearish investors who are looking to profit from what they believe will be another decline in the market.
The phase we really need to pay attention to though is the third phase, known as the Mania Phase. I believe that Mania is a little too extreme of a word to use for this phase, because early in the Mania Phase there is still plenty of profit potential and buying opportunity at reasonable prices. The Mania Phase is characterized by media attention, enthusiasm, and finally greed and delusion culminating with people believing that we are in a new paradigm.
After the new paradigm begins the final phase commenced, which is called the Blow-off Phase. In the early part of the Blow-off Phase there is a bull trap area, which serves to shake out the last of the investors who are continuing to buy on pullbacks when the “smart money” is confident that the market is about to collapse.
To illustrate this ideology, we can look at a picture of the actual S&P 500 in the most recent market bubble from 2003 to 2008.
Looking at this all of the phases are pretty easy to see once they have been highlighted. Notice that the Stealth Phase begins as the market is still falling before the rally. This is, because once retail investors begin to panic and sell their securities, the “smart money” will oftentimes step in and buy what they’ve perceived to be good value opportunities, this beginning the Stealth Phase. Once the Awareness Phase begins, institutional investors start piling on to the rally, and there starts to be more attention in the media and the general public as can be seen in the graph above from 2004 to 2005.
What we want to focus on is the Mania Phase, which lasted a fairly long time, but the most important part of the Mania Phase is at the end of 2006 and the beginning of 2007 when the market had month after month of positive gains with allegedly no end in sight… or was there an end in sight? The end of the Mania Phase has a melt-up effect when the markets begin to rally at nearly a rocket-ship-like trajectory. This is when greed and delusion dominate the logic of the investing public.
The question we have to ask ourselves now is: have we seen that greed and delusion in our economy as we have seen in the past? I don’t feel like we have seen greed and delusion step into this economy as of yet, due to some of the fear that investors have had from being burned in the past. This means that we may still have a strong rally in price in 2018 and possibly into 2019, a rally that could potentially drive us over 3200 in the S&P 500. GMO founder Jeremy Grantham (who is also credited with calling the 2000 and 2008 downturns) believes that this melt-up is possible and in fact will lead the S&P to about 3400 before turning down.
No matter where we are in the bubble cycle, the market looks to have more legs in it to continue its run higher, but the most important key will be knowing when it’s time to leave the party while the going is still good. I have written in the past and made a video on our website about having a “line in the sand” on all of your investments, and a tight “line in the sand” could help you from feeling the unease of a possible strong melt-down after enjoying the nice melt-up.