From Bull to Bear: Why Stock, Futures and Forex Markets Correct

Markets move up because market participants believe in the fundamentals behind the market. At a certain point it is seen that the fundamentals change and the market corrects, however the reason fundamentals change is not because of some external event, but because of the participants themselves. In other words, an excess of bullishness creates bearishness; it is the participation itself in the market that creates the shift and thus the correction or bear market.

To understand this phenomenon, we must first look at how commodity cycles occur.

When commodity prices are high, there is an attraction to produce it, because the high prices offer high profits. When they are low, the opposite happens, because who wants to put all their money into producing a commodity if it is so cheap there is no profit to be had.

If we start at the bottom of the cycle, we’ll be able to understand this better.

Let’s create a commodity called ‘X’. X is a commodity that is used every day by people the world over. X is very cheap, at around $1 a parcel. Because it costs about $3 a parcel to grow, no one is producing it; however this doesn’t stop people consuming it. At this time there is a mound of X in Farmer Joe’s warehouse and so there’s no need to produce it either.

As months go by, the pile of X is stating to diminish, and so Farmer Joe who recognizes that the consumption of X is still constant starts to raise the price; which doesn’t seem to affect consumption all that much, because X is a necessity. After a few more months, Farmer Joe recognizes that he is able to sell X at $7 a parcel without any impact on consumption.

Farmer Joe sees this as an opportunity so he decides to plant some seeds and grow some more X. The only problem is it takes 12 months for X to mature, all the while the mound in his warehouse gets smaller and smaller, and the price at which he is able to sell keeps getting higher. In fact he is now able to fetch $12 a parcel.

Other Farmer’s around the area see what’s going on and decide they are going to grow some X too. Several months ago there was just a large mound of X and no X farms; now there is a small mound of X and plenty of X farms in production.

As Farmer Joe’s farm matures he is able to fetch a nice $12 a parcel for X, and so he is smiling, however not long afterwards, many of the other farms begin to mature also. All of a sudden there is a massive glut of X, which drives the price of X right down, back below $3 a parcel. The farmers who were last to grow X find that they will now have to face a loss.

In this situation, it was the farmers who created the cycle, and not the consumers; who just consume X, and pay what ever the price is on the day. However the price was dictated by the amount of X available, and this was due to the farmers. When there was plenty of X around, the price was low, and when there was very little around, the price was high; however it was the rush to produce more X that created the glut.