The Equity Conundrum Part II: Climbing a Wall of Worry

There are those bullish investors who would argue that the current rally is actually the start of a new, major bull market cycle and not a continuation of the bull that began in the fall of 02, and certainly not the final stages of that 4 ½ year bull. These bullish investors cite the lingering concerns of many investors and the fact that investor sentiment is somewhat cautious. As the market rises, this caution is viewed by the bulls as “climbing a wall of worry”. To understand whether this view has any validity, let’s first look at when and where climbing a wall of worry typically occurs.

Climbing a wall of worry (CWW) typically occurs in the early denial phase of a bull market. The denial phase is one of eight phases of the greed/fear cycle.

The eight stages of the greed/fear cycle are:

1. Denial
2. Capitulation
3. Doubt (corrections)
4. Euphoria
5. Denial
6. Capitulation
7. Hope (rallies)
8. Extreme Pessimism

Stages 1 through 4 occur during a bull market. Stages 5 through 8 happen in a bear market. As you can see, they mirror image each other. Each phase starts with doubt and disbelief, which gives way to acceptance, experiencing periods of doubt (or hope), and culminating in extreme sentiment. (Note: the doubt and hope phases interact with the capitulation phase as corrections or rallies lower or raise investor sentiment.)

It is in stage 1 that CWW occurs. As a new bull market gets underway, hold over thinking from the extreme pessimism phase persists. Many investors find it hard to believe that good times really are just around the corner. And this skepticism adds fuel to the emerging bull fire, sustaining it as early believers feel confident that doubting investors will eventually join the party to take prices even higher.

The real economy counterpart to CWW typically involves an economic environment that is going or has gone from bad to worse. This becomes the economic justification for the skeptics as they hold onto their prior cycle beliefs. Also, during this period, central bankers have begun or are leaning against the wind and providing liquidity to the system that finds its way into both the financial and real economy.

Investment Strategy Implications

Given this brief history lesson, the question becomes “Does today’s bull market and economic environment resemble the above?” If the answer is yes, then you are a bullish CWW advocate. If not, then cause for concern over acceptance of this argument must enter into your thinking.

This is one overriding reason why I find it hard to believe that the markets are climbing a wall of worry.

As I have noted in yesterday’s installment, the deterioration of the fundamental underpinnings for higher stock prices gives me serious pause. In the context of the greed/fear cycle, the economy is not going from bad to worse but from good to okay. I would argue that okay is likely to be followed by bad, not good again. But that’s the essential economic argument, isn’t it? Or we in or did we just experience the pause that refreshes? Or are we in a way station, that calm before the storm really hits? Put me in the latter category.

If this market is climbing any wall it is not one of worry but of a liquidity-juiced enthusiasm.

But what about individual issues? After all, it is a market of stocks and not a stock market? Or so the saying goes. The subject of bottoms up investment decision-making is the focus for tomorrow’s installment.