In our last post we looked at reading the market and the importance of timing your investments. In the post, we'll go on to examine how the market works in cycles and how you can evaluate its health.
Did you know that the market indexes always eventually move into higher ground? Yes it’s true. Sometimes they do move sideways for very long periods (a decade or more) but eventually they always break into new high ground. The most popular market index in the UK is the FTSE 100, which you are probably familiar with, but have you heard of the S&P 500? The FTSE 100 is an index that contains the one hundred of the largest publicly traded companies in the UK and the S&P 500 is the United States' equivalent of the FTSE 100 and contains five hundred of the largest US businesses.
As you can see from the chart above, the long-term trend that the S&P 500 has formed is up. Look closely and you’ll notice that the chart features grey vertical shaded areas and these represent the bear markets. The white areas on this chart are the bull markets. If you take another look, you’ll also notice that apart from the two most recent bear markets, the market has always recovered after significant correction periods and proceeded to move into new high ground. The rule is, after every bear market, the index always eventually moves into higher ground and that means at some point in the future, the indexes such as the S&P 500 will eventually make new highs, far and above the highs made 11th October 2007 when it topped out at 1,576.09. In fact as I write this, it’s currently trading at 1631.38.
The market works in cycles
Bull markets last between two and four years. Bear markets last approximately nine to eighteen months. Because bull markets last longer, the stock market over the long term forms an uptrend. In a typical cycle, you’d normally have three years up and then one year down. The bull/bear cycle then starts again and continually keeps repeating throughout time.
Bear markets tend to end when businesses and the economy are still in a downturn and bull markets often end way before a recession sets in and usually when all the business and economic data looks positive. The market's action is determined by millions of investors and its daily activity is the consensus conclusion of whether investors like or don’t like what they see happening down the road, such as what governments around the world are doing, or about to do, and what the consequences of those actions could be.
Ask the audience
Rather than trying to work out where the market is likely to head next by reading reams of economic data, reading the newspaper or listening to the latest financial news, we would rather see what institutional investors think about what is going on around the world and more importantly watch closely what they are doing. We can very easily see what they are thinking by looking at charts. We can see if they are bullish and aggressively buying stock or if they are bearish and selling. Each and every day we simply analyse what has happened and what it means. We look to see if it was positive, neutral or negative. If over several weeks, the activity is positive, what would that tell you? It would tell you that the market is behaving well and therefore more likely to head north than south. However if the behaviour was negative, it would suggest that the market is more likely to head south.
How to analyse the market's health
Institutions, not individuals, account for nearly 75% of the daily trading activity on the exchanges. That’s why it’s important to watch their activity carefully. The large institutional investors who have the greatest influence on the stock market and consist of investment funds, banks, pension funds and insurance companies.
If these 800lb gorilla investors are buying, smaller more nimble investors like you and me can jump onto their coat-tails. And if these institutional investors are selling, you could quickly switch out on to the sidelines. Here's how it works. Picture the market as a large tree and try to imagine institutional investors being woodcutters. If institutional investors are selling heavily it is like them taking a cut out of the tree and this of course makes the tree weaker. If they take too many swipes at the tree in a short space of time, what is going to happen? That’s right, the tree will fall over. This means the market gets weak when it succumbs to excessive selling which results in raising a red flag. When heavy selling occurs, especially over a short period of time, it’s often a sign to say it’s probably the time to get out of the market. On the other hand, when institutional investors are buying heavily over a short period of time, this makes the market healthy and extremely strong and this is the time we like to be invested.
In our next post, we look at how you can use price and volume charts to read the markets.
As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.
ISACO is a specialist in ISA and SIPP Investment and the pioneer of ‘Shadow Investment’, a simple way to grow your ISA and SIPP. Together with our clients, we have £57 million actively invested in ISAs and pensions*.
Our personal investment service allows you to look over our shoulder and buy into exactly the same funds as we are buying. These are investment funds that we personally own and so you can be assured that they are good quality. We are proud to say that by ‘shadowing’ us, our clients have made an annual return of 12.5% per year over the last four years** versus the FTSE 100’s 7.4%.
We currently have close to 400 carefully selected clients. Most of them have over £100,000 actively invested and the majority are DIY investors such as business owners, self-employed professionals and corporate executives. We also have clients from the financial services sector such as IFAs, wealth managers and fund managers. ISACO Ltd is authorised and regulated by the Financial Conduct Authority (FCA). Our firm reference number is 525147.
* 15th November 2012: Internal estimation of total ISA and pension assets owned by ISACO Investment Team and ISACO premium clients.
** (31st December 2008 - 31st December 2012).
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