Four Stages of Market Turning Points （Doug Kass)

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By Doug Kass        10/12/09 - 01:00 PM EDT

In March, I argued that stocks were at or near a generational bottom and I recently opined that U.S. equities have topped for the year.

It can be argued that there are four classical stages in a move from market bottom to market top and then back again.

Stage One: It is important to recognize that market bottoms are made when investors lose all sign of hope, and fear is the dominating emotion. At bottoms, bears are deified and bulls (like Legg Mason's Bill Miller) are rebuked. Seven months ago, prices were beaten down, and the news flow was consistently reinforcing in its negativity. Economic expectations were uniformly bearish, as the credit and financial system seemed broken. Investors no longer believed. The fear of being in the markets overwhelmed market participants -- so much so that on the day of the yearly low, a poll indicated that more than half of Americans believed we were entering the Great Depression II. Importantly, decades of buy-and-hold investing seemed to vanish and gave way to a preferred strategy of opportunistic trading.

Stage Two: As stocks began their ascent from the March lows, signs indicated that things were getting less-worse as the second derivative recovery commenced. The liquidity put into the system in late 2008 and early 2009 began to flow into the capital markets. Credit spreads improved as the curse of cash began to manifest. In time, fiscal and monetary stimulation began to assert a hold, and improving economic conditions followed.

Stage Three: In time (and with the impetus of higher stock prices and recognition that there were signs of economic improvement), the fear of being in began to be replaced by the fear of being left out. As deflated company forecasts turned out to be too pessimistic, the news (importantly influenced by aggressive cost-cutting) improved, and share prices moved comfortably above the March lows.

Stage Four: Tops are born out of a rally in optimism and when bullish commentary multiplies. At tops, bears are chastised, and bulls (again like Legg Mason's Bill Miller) regain their popularity. (See this weekend's Barron's cover story of Legg Mason's Bill Miller!) And at tops, investors want to believe.

My position has been well-chronicled on The Edge, my exclusive trading diary on RealMoney Silver: I believe that it is different this time.

From my perch, the prospects for a self-sustaining economic recovery are in doubt in the face of numerous headwinds that are not only consequential in scope but with some of those forces that didn't even existed in the last few recoveries out of recessions. Despite the celebration of the certainty in a smooth and reinforcing recovery that seems to be at the foundation of the bullish cabal, the magnitude of policy (both monetary and fiscal) decisions speak volumes of how fundamentally different conditions are in October 2009 vis-a-vis past cycles. Moreover, the due bills from those remedies and the timing and response to the withdrawal of the outsized stimulation in 2008-2009 add further to the uncertainty of the slope of future economic growth and poses risks anew.

Whether the stock market is topping out and the economy's 2010 trajectory will disappoint is subject to debate (on RealMoney and elsewhere), but what probably can't be debated (and something that truly astonishes me) is the brief period of time in which we have moved from fear to greed.

Finally, as an exclamation point to today's column, I again bring up portfolio manager Bill Miller. While this is not meant as an ad hominem attack on the legendary investment professional, it is almost impossible for me to fathom that despite managing a fund that was down by more than 70% in the 18-month period ending March 2009, he is once again being praised -- and has gone from goat to hero in seven months -- in this weekend's Barron's magazine cover story.

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