There are six phases of market mood in Cheung’s model:
- Normal— This is the base-building or consolidation phase where fundamentals are poor but stabilizing. Value investors are showing interest.
- Hypomania— Favorable news shocks hit the market, and prices break higher out of consolidation. Speculators, focused on short-term gains, begin buying. As the market continues higher, positive feedback ensues.
- Mania— The uptrend is very strong. Favorable analyst reports predict further gains, adding fuel to the fire. Sophisticated and novice investors alike are swept up in the market. Positive feedback is very strong as stories of big profits entice ever more speculators. Some smart money investors quit buying and begin to pare holdings, but consensus is overwhelming that more profits are to come.
- Moderate depression — The market peaks and begins to fall. Bulls become indecisive, and a narrative that questions the bullish story begins to build. Some buy on dips, expecting a rebound and further gains. Professionals increase short sales. Falling prices create a negative feedback loop. Investors begin to panic. Prices decline quickly.
- Major depression — The trend is very bearish and stories are resoundingly negative. Negative feedback mechanism is prevalent. Those who have not sold their positions in phases 3 and 4 are distressed and depressed, many “throw in the towel” and quit following the market.
- Normal— Selling has abated as bubble buyers have exited, but new buying interest remains weak. The market is “washed out.” Fundamentals are poor but beginning to stabilize. The market transitions back into phase 1 and value investors again begin accumulating, starting the cycle over again.
Knowing that the mood of the market is part of a cycle may help investors catch a trend early, before it becomes a bubble, and ride it profitably with appropriate risk management, expecting that market mania will inevitably cycle back to market depression.
While we may not be able to fully calculate the madness of men, an understanding of the bipolar cycle may help an investor do what Warren Buffett says is at the heart of his investment philosophy: “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.”
“You are neither right nor wrong because people agree with you.” Another way of saying that wisdom, truth, lies elsewhere than in the moment’s moods. – Benjamin Graham
“If you can keep your head when all about you are losing theirs … maybe they know something you don’t.”- Buffett
“Now is the time to invest and get rich.”-Buffett’s
So far I have been talking about the virtues of the value approach as if I never heard of such newer discoveries as “the random walk,” “the efficient portfolios,” the Beta coefficient, and others such. I have heard about them, and I want to talk first for a moment about Beta. This is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the Beta idea with the concept of “risk.” Price variability yes; risk no. Real investment risk is measured not by the percent the stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power economic changes or deterioration in management.
The value approach is always been more dependable when applied to senior issues than to common stocks. Its particular purpose in bond analysis is to determine whether the enterprise has a fair value so comfortably in excess of its debt as to provide an adequate margin of safety. The standard calculation of interest coverage has much the same function. There is much work of truly professional caliber that analysts can do in the vast area of bonds and preferred stocks–and, to some degree also, in that of convertible issues. The field has become an increasingly important one, especially since all well-rounded portfolios should have their bonds component.
Let me close with a few words of counsel from an 80-year-old veteran of many a bull and bear market. Do those things as an analyst you know you could do well, and only those things. If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, that’s the row you should hoe. If you are really good at picking stocks most likely to succeed in the next 12 months, base your work on that endeavor. If can foretell the next important development in the economy, or in technology, or in consumers’ preferences, and gauge its consequences for various equity values, then concentrate on that particular activity. But in each case you must prove to yourself by honest, no bluffing self-examination and by continuous testing of performance, that you have what it takes to produce worthwhile results.
If you believe–as I’ve always believed–that the value approach is inherently sound, workable, and profitable, then devote yourself to that principle. Stick to it, and don’t be led astray by Wall Street’s fashions, illusions, and its constant chase after the fast dollar. Let me emphasize that it does not take a genius or even a superior talent to be successful as a value analyst. What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.