The bull market has entered a new phase

By David Schwartz
Published: December 4 2009 18:01 Last updated: December 4 2009 18:01

I wear two stock market hats. Many of my trades remain open only for a brief period. But I also think a great deal about long-term stock market prospects. I believe that having a long-term perspective provides me with a significant short-term trading edge.
History can be a useful tool when it comes to formulating views about the future. For example, my review of past bull markets shows that most go through two distinctive phases. But the issues that trigger each phase can differ.
The opening phase of a bull market is rarely due to a single event or news flash. Rarity is what made the Federal Reserve’s rate cut in October 1998 so memorable – it was an emergency measure after the near-meltdown of the Long-Term Capital Management hedge fund. Shares rallied sharply for nine months in the aftermath of that action.
More typically, it is a series of related events that cause investor sentiment to shift to a bullish mode. These triggers are often linked to the underlying economy, such as improvement on several forward-looking economic indicators.
But economic improvement is not a necessary pre-condition for the first stage of a new bull market. A powerful rally began in January 1975, which saw shares more than double in 12 months, despite horrid economic conditions that continued for several years. The main trigger for the rally was that selling pressure by disheartened investors had finally tapered off.
The current bull market appears to be a re-run of 1975. Investors finally accepted earlier this year that the ongoing economic downturn was a recession, not a re-run of the Great Depression. Stock markets rose sharply since their March lows despite no sign of near-term economic improvement.
Unlike stage one, history teaches that the second stage of a bull market nearly always has an economic link. If there are no signs of significant growth in the next six to 12 months, significant “phase two” rallies do not occur.
I suspect that phase one of the current bull market has run its course. Most investors recognise that we are not in a re-run of the Great Depression. This is probably now in the price.
Another point is that shares rose indiscriminately in the first six months of this rally. Companies suffering from weak sales or capital inadequacy, as well as healthy companies, made strong gains.
These across-the-board increases appear to have ended. Investors are now more discriminating and are focusing on prospects for specific companies. Fresh forward-looking management statements are now triggering bounces or sell-offs for a specific share, but not for the broader stock market.
This behaviour leads me to conclude that we have now reached phase two of the ongoing bull market.
If I am right, broad economic prospects for the future will play an increasingly important role in stock market profitability. It has become fashionable to treat the booming Chinese economy as a western stock market booster, but we must not forget that the US is still the world’s largest economy. UK shares are heavily influenced by what happens on Wall Street and Main Street.
So what lies ahead? The most recent batch of economic statistics from both sides of the Atlantic continues to disappoint. In the UK, the economy remains severely damaged. Retail activity is weak. Residential property is limping. Bank lending lags – despite claims to the contrary by the banks.
Across the Atlantic, last week’s economic reports were also disheartening. The start of the Christmas buying season saw weaker Black Friday sales than hoped for. Unemployment continues to rise, but at a slower rate. A number of other government-issued reports also disappointed investors.
Even when the news was good, some important warning signals were buried in the data. The latest reading of economic activity from the Institute of Supply Management (ISM) came in at 53.6. As a rough rule of thumb, scores above 50 are thought to be positive for the future. However, this month’s figure had slipped steeply from the previous month.
Ian Shepherdson, of High Frequency Economics, warns that strong economic recoveries are generally associated with ISM scores above 60. He also observes that ISM data are drawn from a cross-section of very large companies. Small companies are not represented and they account for half of total gross domestic product in the US.
The conflict between heavy spending by large companies and lower spending by small companies with poor access to bank loans will be played out in the next few months. For the moment, mildly positive news from this data must be taken with a grain of salt. On balance, there is little reason to expect a healthy US growth spurt in the near future.
Should the economy start to grow strongly, I am confident that stock markets on both sides of the Atlantic will rise. But, given the huge advance we have enjoyed in 2009, I fear that, if the US economy does not show unequivocal signs of solid growth, prospects for the next six months might be disappointing.

Stock market historian David Schwartz is an active short-term trader writing about his own trades and strategies. Send any comments or suggestions to tradersdiary@ft.com