Various Stages in a Bull Market and How to Invest in Each

This is Troy’s second post here at One Smart Dollar. Check out his first one here.

It’s easy to make money in bull markets. All you have to do is buy, hold, and do nothing. That’s why in bull markets, every one makes money except the perennial bears.

However, what if we want to increase our investment returns in bull markets? Doesn’t that mean we’ll have to actively buy and sell various securities? The answer is a resounding yes. Below are the various stages of a mega-bull market (approximately 4-6 years), and how to invest profitably in each stage.

The V Shaped Recovery

Preceding every big bull market is usually a bear market, which ends when investors panic and lose all sense of rationale.

There are two widely accepted types of market bottoms: a V shaped bottom and a U shaped bottom. The essential difference between these two is obvious:

1. A V shaped bottom is very quick. The market hits bottom and instantly rebounds upwards, ending the bear market. After the first rebound, the market might fall a little, but never towards the previous market low. Soon, the bullish ascent continues
2. A U shaped bottom is long and drawn out. The market will stay near the bottom for a long time, forming a wide, U-shaped bottom (hence the name).

Every time the market has stabilized after it crashes, the academics come out with the “is this going to be a V shaped or a U shaped recovery” question. As if anyone even needed to ask a question.

In most cases, the market experiences a V-shaped recovery (although this is not true for economic recoveries). Why? Because at the end of bear markets, a lot of shorts (sellers) have their shorts all strung out. They’ve poured all their money into bearish positions. All it takes is for one massive buyer to swoop into the market and create some massive short covering.

That is why many markets experience a massive rally immediately after the market bottom. That massive rally can only be caused by autopilot short covering.

(For those of you who don’t know what short covering is, short covering is when the market reaches a short seller’s preset stop loss. When that happens, the short seller’s account will automatically buy back the shorts. That’s why the rally is so strong – this automatic buying creates massive bullish pressure.)

How to Invest in This Stage

Whenever the market reaches panic selling, I just dump all my money into bullish positions. Maybe the market will fall even more, but I can’t be far from the bottom. Here are my criteria:

1. Panic. I want to see people panic and just dump all their holdings. And I don’t mean any regular panic selling. I mean “oh crap there’s no bottom to this bear market” kind of panic. People need to believe that there is no bottom for this bear market.
2. Extremely bearish sentiment. There are certain organizations that gauge investor sentiment (whether investors are feeling bullish or bearish). Among these, I find that AAII is the most accurate. Whenever investor sentiment is ridiculously bearish, the end of the bear market is near.

The Swing Stage

This stage tends to be relatively short. Because stocks have been falling for so long prior to the market bottom, right now a lot of investors are still skeptical. Thus, whenever prices rise, they will be beaten down again (by the skeptics and the bears). As a result, the market swings back and forth.

How to Invest in This Stage

This stage is great for swing traders. Buy when the price falls, sell when the price rises. The question is, how do you determine when to buy and when to sell?

I use a indicator called RSI (Relative Strenght Index). This index judges the relative strenght (momentum) of the market. When the market goes up for multiple days consecutively, the RSI will be high. Whenever RSI is high, I sell the market. When the market consecutively goes down for several days, RSI will be low. When RSI is low, I buy into the market.

The Healthy Bullish Profits

When the swing stage is over, the market will assume a healthy but steady uptrend. Along the way there will be regular corrections, but the overall market trend is up.

How to invest in This Stage

This is the stage where I like to buy and hold. To quote Reminisces of a Stock Operator, “it’s a bull market you know!” Too many people try to trade this market when they can be making more money just by holding onto their bullish positions. If you buy and sell positions back and forth, you’ll probably miss out on some of the big market movements (less profits!).

The absolute worst thing you can do in this stage is to go short because you predict a bearish market prediction. Sometimes these predictions just don’t happen when you expect them to. As a result, your short positions are against the mega- uptrend resulting in huge losses.

The End

This is the final stage of the bull market, when prices start to rise at a much faster rate. The beginning of this stage is when massive amounts of mom-and-pop money start to move into the market. Conversely, this is also when some of the “smart” money gets out.

Personally, I don’t get out when the Average Joe’s money moves in. From my own experience, I’ve learned that after record amounts of cash pour into the market, the bull market still has several months to go. As a result, I like to scale out my bullish positions. For example, I’ll sell a fifth of my positions every X% that the market goes up. That way, I don’t get caught when the bull market ends and comes crashing down, but I’m also not sitting on the sidelines watching everyone else except me make money.

Troy writes for The Financial Economist, an online community about investing and market insights. When he’s not working, Troy enjoys working out and archery. Cheers, and see y’all soon!