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The Phenomenology of the Bull Market

All bull markets are unique, yet market analysts can make several universally valid statements about the market.

First, over the lifetime of the trend, speculative transactions gain in their importance that is they tend to increase during the lifetime and become self-reinforcing trends.

057768c7 8367 4db8 943f 2d85bced90d3.pngSecond, the prevailing method of forecast and strategy is a trend-following, and the longer the trend persists, the stronger the belief in this method becomes.

Third, it should be clear to anyone that once a trend is established, it tends to persist and to run its full course; when the turn finally comes, it tends to set into motion a self-reinforcing process in the opposite direction.

These three statements are the knowledge that proceeds to the following theoretical deductions.

Therefore “it is the growth in speculative capital flows moving in a trend-following fashion that makes the trend so persistent, and it is the persistence of the trend that makes a trend-following bias so rewarding, and it is the rewards reaped by speculation that attract increasing amounts of capital.”

Furthermore, as the trend ages, there is nothing of any substance to guide speculators, but the market itself, and the market is dominated by trend followers. They may rationalize their actions, but they depend on the trend. It is its own “advertisement.”

It also follows that bears who actively fight the trend are progressively eliminated, and only the engaged “trend followers” survive.

Eventually, a crossover point will be reached, even without the intervention of the authorities, when the inflow of speculative funds could not keep pace with the cost of the budget deficit and its rising interest obligations, etc., and the trend would have to be reversed.

I have mentioned many times that the methods of the big banks and capital managers are trend following with systematic execution. So, when the reversal sets in, it could easily be accelerated into a free fall. In other words, when a change in trend is recognized by the trend-following models, the volume of speculative transactions can undergo a dramatic increase, to the extent that even governmental intervention is not bigger than the change in the tide.

What all good capital managers, traders, and hedge fund strategist know is that while a trend persists, speculative flows are incremental, we leverage up, a/k/a parlay. With that in mind, envision the unwinding of these positions and/or the engagement of short selling hedges in the equities, options, and futures markets.

Sure, there is a chance, like 1973-74, where market participants recognized a change in trend only gradually. There were not mini-panic days during its decent – range days greater than 4%- the damage was done just not in transfer of wealth to cash accounts but over a longer than average period. That may be because the bear market started in the face of a good economy* but was foreshadowed by Geopolitical events that the market is not very good at discounting.

Also, the authorities are bound to be aware of the danger – trillion-dollar deficit and a spent fiscal and monetary policy - they may try to do something to prevent the reversal or, worse yet, a crash. But the current QE can be seen in two ways, one as a dire warning; more importantly, once “the powers that be” become convinced that a Regime change is coming, they will dump the problem on the next admin to worry about. “One for all and all for one and every man for himself.”

Equity investment – speculation- is progressively destabilizing not because the speculative capital flows must be eventually reversed, rather because they need not be reversed until much later. The younger a bull market, the much greater the capital accounts will be and able to provide a welcome cushion, thus making the adjustment less painful.

With an older bull market, active investors are dependent on the trend, and when the turn comes, the adjustment becomes that much more painful.

* The U.S. economy in 1972 enjoyed prosperity marked by comparatively stable prices, a high real growth rate (6.4 percent) and a fall in unemployment (5.1 percent at the end of 1972)

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