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Why do we Even Have Bull and Bear Markets?

Posted On: Thursday, November 3, 2022

Why do we Even Have Bull and Bear Markets?

Last year, shares in the company that owns Facebook – Meta Platforms – were up over 23%. So far in 2022, they have lost more than 60%.

This is just one extreme example of how market conditions have changed. Last year, almost everything seemed to be going up. This year, it’s difficult to find a market that hasn’t lost value.

In some ways, this doesn’t make a lot of sense. Facebook is pretty much the same company it was in 2021, so why should it suddenly be worth less than half as much?

Share prices in general have also gone down, even though company profits and sales are still going up. Earnings by South African listed companies have been improving, and many are showing better profitability than people expect.

But that hasn’t stopped share prices from going down. 

The sentiment train

These contradictions in the stock market can be difficult to understand.

We know that, over the long term, company profits and the stock market will move higher unless there is a total catastrophe. For example, the JSE All Share Index is six times higher today than it was just 20 years ago.

So why doesn’t the stock market keep moving upwards if listed companies keep growing their profits? Why don’t those two things just align?

The biggest reason is that stock market prices are determined by sentiment as much as they are by the cold, hard numbers on income statements and balance sheets. Linked to this is the fact that markets are also forward-looking. A company’s share price doesn’t reflect what investors believe that business is worth right now so much as what they expect from it in the future.

When buying a share, investors are really buying some of its future profits. What those profits will be, however, isn’t known. And so, depending on how optimistic or pessimistic investors are feeling at the time, they may be expecting a lot more than will realistically materialise – or a lot less.

Shifting tides

The trouble with sentiment, is that it can change very quickly. Anything from rising inflation to fears of recession to political issues or a global pandemic can influence how investors are feeling.

In 2020, for example, no one really knew how badly company profits would be affected by Covid lockdowns. But the overall sentiment was bad enough that markets lost a third of their value in just a few weeks.

And when governments and central banks announced stimulus packages to help the economy, they bounced up again.

This illustrates another impact of sentiment on markets, which is the principle of mean reversion. What has always happened, and what is probably always going to happen, is that when investors start to feel particularly positive or negative, that optimism or pessimism feeds on itself.

When people feel really good about the future, they are willing to pay more for shares in companies they like. Those share prices then go up because people are willing to pay more for them, and so they become even more attractive. People then feel more positive about the future because they have grown wealthier.

The same effect happens on the way down. The more negative people feel, the more share prices drop, and so the worse they feel.

In the end, however, these cycles inevitably collapse on themselves because the reality of company profits and cash flows always shines through at some point. And that’s when things revert to the mean.

Back to the start

In a bull market that has gone too far, investors start to realise that the money they are paying for future profits is unlikely to ever actually be recovered. The huge profits they are now paying for just aren’t going to be there.

Since the future doesn’t reveal itself all at once, this happens very slowly. Bull markets can therefore run for a long time, well beyond the point of being rational.

When markets crash, however, investors tend to realise much more quickly that they have turned too negative. When companies start to show that profits haven’t completely dried up the market starts to feel better again.

Either way, this leads to a reversion. Optimism swings towards pessimism, or the other way around. And so, markets look to return to something more normal.

The trick is, of course, that they never settle at a reasonable average. That is because, one way or another, the fading optimism or dissipating pessimism leads into its opposite. 

And, as that sentiment grows, the cycle just starts again.

To discuss your long-term investment strategy, speak to a professional.

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