Trading the Market

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During a bull market, the stock market is buzzing with activity. The investment public is actively buying and selling shares and trading volume increases. For example, in March 2000, technology stocks were on fire; on the NASDAQ Stock Market, average trading volume approached 2 billion shares a day. Today, a little more than 1.5 billion shares trade hands daily. The dollar volume related to trading activity is even more telling. At its peak, the dollar value of daily trading activity on the NASDAQ surged to $100 billion! By the end of 2002, the number had fallen to only $20 billion. The rise and fall of the NASDAQ from 1998 to 2002 provides an example of two different types of market environments: a surging bull market and a tumbling bear market. Bull and bear markets have existed throughout history and will continue to exist far into the future. Prices rise and prices fall. As prices move higher and lower, trends develop. These trends can last from a few days to a few decades. More often than not, the development of the trend is based on fundamental developments. For example, bull markets in stocks begin when the economy is expanding, corporate profits are growing, and investors are willing to buy shares. At the same time, trends can only last as long as investor psychology remains supportive. Bull markets continue as long as investor sentiment remains positive and upbeat. In fact, bull markets often end when investor optimism reaches unsustainable levels, or when bullishness reaches an extreme. It is the dynamic interaction between fundamental developments and crowd psychology that dictates the strength and duration of bull markets. Understanding this dynamic, and how to view events as they unfold with index charts, is a key element to becoming a successful index trader.

BULL VERSUS BEAR MARKETS

A bull market is characterized as a period of rising prices. It gets its name from the fact that bulls buck up with their horns. A bull market can occur in stocks, bonds, gold, or even in the market for a fine red wine like a Chateau Margaux. Any investment, asset, or security that has a market with changing prices can witness a period of rising prices, a bull market. In the stock market, bull markets are easy to identify. Investors feel confident, as stock prices rise and portfolios increase in value. You can hear colleagues or acquaintances boast about their stock returns at work or dinner parties. The media pays greater attention to the stock market’s performance and there is a general sense that all is going well in the corporate world and the economy. During bull markets, investment banks are selling shares of initial public offerings (IPO) faster than hot dogs at the ball park. For example, in March 2000, investors were falling all over themselves for the latest technology IPO. When trading activity is robust and the public is active in the market, investment banks can generate hefty fees for bringing new companies to the market. As a result, in 2000, a record number of new offerings hit the market, as more than 400 companies brought new stock to the public. In addition, shares would sometimes jump 100, 200, or 300 percent during their first day of trading. The IPO market died a couple of years later and investor disinterest kept the market quiet for years thereafter. Mutual funds have steady inflows of cash during bull markets. When investors see their 401Ks and retirement accounts increase in value, they add more money to their mutual funds. In March 2000, investors poured $35.6 billion into stock mutual funds according to the Investment Company Institute (ICI). In addition, total assets rose from $4.22 trillion to $4.43 trillion during the month of March 2000. A couple of years later, ICI reported that investors withdrew $466 million and stock fund assets fell from $2.67 trillion to $2.6 trillion in January 2003—a far cry from the March 2000 levels. While investors feel a general sense of optimism and wealth during a bull market, the opposite occurs in a bear market. During bear markets, prices are falling and investors are losing wealth. A sense of uneasiness develops and, if the trend persists, can give rise to high levels of anxiety or angst. As this happens, buyers are less likely to surface and investors will sell off some of their holdings to avoid further losses. A long-term bear market is often accompanied by negativity and pessimism. The news headlines are often grim and the stock market gets less coverage from the media. As the bear market reaches its final stages, however, the selling can become extremely heavy, causing volume to rise, as the last remaining bulls finally throw in the towel. This is sometimes called a final “washout” or a phase of “capitulation” that occurs at the very bottom of the end of the bear market. At that time, the media is clearly focused on the gloom and doom. Headlines about market crashes make the cover of major magazines. But at that point, the selling begins to ease and seeds are planted for another bull market