Bull Market Basics, Part Two: Why And How Do Bull Markets Occur?


February 20  

This is part two of a series on bull markets, specifically on why and how bull markets occur. Click here for part one.

The nature of investing is that the markets go up and down in regular cycles. A bear market is followed by a bull market and back again with stagnant periods of relatively little movement sprinkled in. Just as bear markets often have rallies within them, so do bull markets sometimes have corrections within them. There is little we can guarantee in the world of investing—except that prices will fluctuate continuously, usually in somewhat regular patterns.

Why do bull markets occur?

In a perfect world where investors only value companies by fundamentals like earnings and profit numbers, there would be no real bull or bear markets. Stock prices would go up somewhat steadily as long as companies are growing. Investors wouldn’t be spooked by what’s happening in the economy or react to a headline that sounds better or worse than it actually is. Investment decisions would be made with a cool head 100% of the time.

However, we don’t live in a perfect investment world, and we never have. There have always been cases of runaway valuations involving everything from tulip bulbs to stocks, real estate and more. While bear markets often occur in reaction to troubling economic times or periods of a slowdown in the economy, bull markets generally occur because investors are feeling good about the macroeconomic environment. All they see is green pastures all around them, and they’re feeling so good that they just keep sending prices up, up and away. After a while, it starts to look like there will never be another downturn, although there will always be another pullback eventually.

Phases of a bull market

Just as bear markets have phases, so bull markets tend to follow clear stages as well. Since bull markets typically follow bear markets, they usually start with a period of recovery from the bear market. Prices start to normalize after having been in a downward spiral for varying lengths of time. In many cases, this normalization in asset prices precedes the normalization in the economy. Some economic indicators may start looking better than they did during the bear market, and they’re just good enough to start drawing investors back into the market. Sometimes the initial leg up can be rather steep.

The second phase of a bull market is a steady climb which occurs in step with the economic improvement. Prices are starting to pick up some steam. Although this phase might not be as steep as the first phase, it can last longer and is marked by a general uptrend.

The third phase is what many now refer to as “irrational exuberance,” a term coined by former Federal Reserve Chairman Alan Greenspan in the 1990s in reference to the dotcom bubble. In this stage, prices have picked up a great deal of momentum and just keep climbing higher, showing no signs that things will ever slow down again. This last stage is marked by a general belief that the bull market will never end because there are no signs that there will ever be a major downturn again. Investors seem to forget that markets move in cycles, and the next bear market is always inevitable, even if it is a long time coming. During this phase of the bull market, it seems like there is no limit to what investors will pay for certain assets.

Price bubbles

There are two main features of bull markets that deserve our attention, which are bubbles and corrections. Irrational exuberance almost always results in a bubble in one or more assets. Bubbles inflate because investors just keep pouring more and more money into a particular asset, ignoring valuations entirely. In the case of the dotcom bubble in the late 1990s, investors couldn’t get enough tech and internet stocks. Many tech companies held their initial public offerings during this timeframe because investors would buy any internet-related stock. However, some of those tech companies didn’t survive after the bubble burst because their business models were unsustainable.

Another example is the 2006 housing bubble in the U.S. Home prices continued to climb higher and higher until they peaked in 2006. Banks were giving mortgages to people who really couldn’t afford them, which resulted in higher foreclosure rates in 2006 and 2007. The subprime mortgage crisis ensued as foreclosure rates climbed. When the housing bubble burst, it caused a recession in the U.S. from 2007 until 2009, when the current bull market began.

Bubbles burst when most investors finally come to their senses about the prices they are paying for different assets. In the case of the housing bubble, rising foreclosure rates drew attention to the problem that was created by soaring home prices and the run on subprime mortgages, which are home loans given to people who have especially weak credit scores, sometimes even lower than 600.

In the case of the dotcom bubble, investors ignored tech companies’ cash flow problems because they feared missing out on the next big thing in the realm of technology. Unfortunately, many companies went broke due to their heavy spending habits and mindset of putting growth before profits. In some ways, Greenspan himself may have helped this bubble pop by announcing a plan to aggressively raise interest rates, which caused some investors to worry about the impact on tech companies, many of which borrowed money to fuel their growth-over-profits practices.

Bull market corrections

Aside from bubbles, it’s also important to point out that when bull markets occur, prices aren’t always going up. The broader trend is up, but sometimes corrections occur, which means prices will slide at different times during the market cycle. In some cases, a correction will occur between each phase of the bull market, although there can be corrections during any of the phases as well.

Corrections are a decline of usually no more than 10% to 20% from the most recent peak, although they can be a bit deeper than that. Corrections can last anywhere from days to months. CNBC reported that the average correction in the S&P 500 lasts four months and sees prices decline 13%, unless it turns into a bear market.

It’s impossible to predict corrections, but technical analysts try to do it by studying support and resistance levels in an attempt to predict price reversals. In the case of a bull market, the big question is whether the price drop is merely a correction or whether it will develop into a full-blown bear market. If it remains a correction, then the bull market is intact.

The next article in this series will focus on investor psychology in bull markets and how to invest in them.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost