I'll admit that I haven't read many of the great works of literature.
Even though I read a great deal, almost all of my reading is related to the stock market. (Hopefully, there will be time to read more literature when I retire.) But sometimes, the two intersect in unexpected ways, and I find myself benefitting from the works of great authors.
I frequently find myself thinking about quotes that others consider to be important and symbolic of the work. One quote many personal finance writers like to share is from Ernest Hemingway's classic "The Sun Also Rises."
"How did you go bankrupt?" Bill asked.
"Two ways," Mike said. "Gradually and then suddenly."
When we boil water on the stove, the temperature appears to change "gradually and then suddenly." When a child is getting sick, their behavior seems to change "gradually and then suddenly." When someone struggles at work, their performance often seems to change "gradually and then suddenly."
Of course, with the child or the worker, the gradual changes are often only spotted in hindsight. The child might not want to play outside on a sunny afternoon, pick at dinner, and then be sick that night. Parents reviewing the day realize the signs were there, but they didn't notice.
By now, you've probably realized where I'm going with this...
I believe the stock market follows this "gradually and then suddenly" process as well.
Right now, we seem to be seeing gradual changes. In the chart below, the price of the S&P 500 Index appears to be gradually moving to its old highs.
This can be explained by how investors view the market. As prices fell suddenly in the fourth quarter, investors became concerned about a bear market and increased the amount of cash they usually hold. The Federal Reserve data shows that behavior.
The next chart shows the amount of cash that individual investors have in money market funds. Money markets are a virtually risk-free asset and probably the simplest place for an individual to hold cash in a brokerage account. The amount of cash in money markets jumped sharply as the stock market sold off last year (as shown in the chart below).
Source: Federal Reserve
Large investors also turn to money markets when they are worried about price declines. That can be seen in the next chart, which shows assets in institutional money markets. These are funds available to investment managers at hedge funds, mutual funds, and other large firms. Here, the jump in assets is even more noticeable.
Source: Federal Reserve
Combined, there is more than $2.7 trillion in cash sitting on the sidelines in money markets. These funds pay little (if any) interest. That means they are a drag on performance. A manager with 10% of her assets in cash is concerned about underperforming in a bull market and is likely to gradually put assets to work in the stock market.
A "Hemmingway" Market
Investors are gradually buying stocks, and that's pushing stock prices up. Eventually, they're likely to become complacent and will expect the gains to continue. This will result in large amounts of cash entering the stock market, and price gains will accelerate. In other words, watch for the bull market to rise "gradually and then suddenly."
I realize Hemingway wasn't trying to explain how the stock market works (or how my children get sick) when he wrote that book. But his words can help me understand these patterns. With an understanding of what to expect, I can be more prepared for the ups and downs of the stock market.
Even while I expect the gradual increase in prices to continue, I know there will be pullbacks along the way.
My interpretation of Hemingway can also explain why we see pullbacks. For the person headed toward bankruptcy, this could be similar to the day they receive the monthly credit card statement. For a few days, they try to avoid the inevitable and spend less. But the shock of the balance due wears off after a few days and they resume the relentless drive toward insolvency.
In the stock market, pullbacks can develop as investors stop buying, concerned that prices are getting ahead of fundamentals. After a brief dip, investors spot value again, and the buying resumes.
This process can continue for some time, and it's been going in the current stock market for some time. I believe it's likely that the broader stock market average will continue moving cautiously higher for a few more weeks as we head into the hectic part of earnings season. Those quarterly reports could shock investors, and we will know shortly.
This week, we have earnings reports from a few banks, including Wells Fargo and JPMorgan, who will report before the open on Friday. After that, we should see dozens of reports a week, and the reaction to those reports will tell us what to expect.
Within a month, we are likely to have a better idea of whether prices will continue to move gradually higher or suddenly reverse to the downside. The good news is that either market is tradable and potentially profitable, thanks to strategies like the one we use over at Income Trader.
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