I like to think about the stock market and how it relates to investor psychology.  Specifically with market tops and market bottoms.  As we look back over the last 10 years, there is a debate over where the bear market, that we may or may not still be in, actually started.

When Did The Bear Market Begin?

There are two common answers to this question:

1. The bear market began in 2000 with the bust of the dot-com bubble
2. The bear market began in late 2007 / early 2008

Depending on which chart you look at, you can make a case for either.  The Nasdaq 10 year chart pictured below supports the idea that it began in 2000.  The S&P chart supports the latter argument since it reached its all time high in late 2007.

NASDAQ Chart

S&P Chart

If you price the market in gold, it tends to support the argument that the bear market began in 2000 since the market priced in gold peaked in 2000.  Since then, the market has been flat or down and gold is up significantly.

The problem with the gold argument is that when it comes to investor psychology, the market priced in gold does not tend to have an impact since the masses follow the nominal value of the market, not the market priced in gold.

Even still, I tend to believe that the bear market started in 2000 and still has years to go.  I will explain why.

Focusing On Psychology

First, let’s examine what market sentiment or market psychology is at the market top.  For the market top, let’s use the peak of the Nasdaq bubble in 2000.  Everybody wanted to get into stocks.  Taxi drivers were buying tech company IPOs.  For a similar scenario, think about the real estate bubble where EVERYONE wanted in.

Now, at least in theory, a bottom should be the opposite psychology, right?  The opposite would be the scenario where stocks are untouchable.  Nobody wants anything to do with them.  While, we got close to this mentality in March of 2009, it’s pretty clear that many people are still into stocks even if it’s significantly less than the top in 2000.

I believe that it takes multiple crashes, at least three, in order to achieve this “bottom” in market sentiment or psychology.  If we started in 2000, we’ve had two crashes, meaning we still need one more.

Why We Need Three Crashes (or more)

For decades, Americans were conditioned that we should all have a stake in the stock market.  Yes, our allocation to risky assets like stocks should diminish as we get older, but stocks are the way to go for the most part through life.  We were led to believe that stocks are a guaranteed return.  A good return.  Many believe 10% annually.  Only when we’re talking long-term, of course.  With such a consensus opinion among the American public, it takes repeated disappointment to shatter this view.

Let’s go back to the real estate example quickly.  If you take this concept about a market bottom and apply it to the real estate bust, it is obvious we still have several crashes to go to where the public views real estate as a terrible investment, dead money, an investment of last resort.  Even after the disastrous bust in the real estate market, you still have some people who believe now is a good time to buy.  Now is a good time to flip a property.  Clearly, the boom is still too recent in memory to where there are still buyers out there.  Again, not a real market bottom.

If this theory is correct, we should have at least one more significant crash in stocks in the next year or couple of years.  This crash coupled with the memory of the other previous stock market crashes will create such a sell-off where stocks would hit a real bottom.  A few marks of a potential real bottom might be:

• A Dow / Gold ratio at 1:1 or at least near 1:1 – Currently, we’re at approximately 9.35:1
• Very high dividend yields – Yields are much to low right now to signal a bottom
• Very low P/E ratios – a real market bottom will have depressed P/E ratios below historic norms

Potential Reasons Why It Might Not Play Out Like This

While my theory described in this article is a definite possibility, let’s talk about why this subsequent crash might not materialize.

The number one reason why this might not materialize is the U.S government.  You cannot underestimate the U.S. government and its ability and determination to prop up the economy including the stock market.  Their response since the crisis began in 2008 was to drop interest rates to zero creating a huge inflow of liquidity that has helped stock markets skyrocket from March 2009 lows.  The increase in stocks has allowed many companies to raise capital and avoid bankruptcy.

Be assured… the government will do whatever is necessary to prevent another crash especially in the near term.  Eventually, market forces will over power even the government, however, and a crash will be unavoidable.