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NEW YORK (
) -- "When you're in the midst of a bull market, you need to take advantage of it and use it to the fullest extent possible," Jim Cramer told the viewers of his "Mad Money" TV show Wednesday.
He said that by dissecting a bull market and understanding how it works, investors can avoid being misled by the often confusing media and focus on what matters most.
Cramer said the first thing investors need to know is that bull markets are all about leadership. He said that every bull market is lead by a sector or sectors that drive it higher. Identify the leaders, said Cramer, and you'll identify the winners.
How do you identify the leaders? Cramer said they're the first groups to rally off the bottom, and often rally hard in a "V" shaped pattern. These are the stocks that start roaring right from the opening bell. Once these leading stocks and sectors take off, the rest of the market will follow, he said.
But leaders do more than just begin bull markets, said Cramer, they also begin corrections as well. He said that typically the leaders will roll over first, with the rest of the markets again following suit. It's at this point, he said, the media will forecast doom and gloom and novice investors panic and sell. But that's a mistake, since these pullbacks are the best time to buy back into the leaders.
Cramer said pullbacks are buying opportunities, if investors know which stocks to buy. He said not to be faked out by pullbacks and the media's reaction to them. Instead, he said, use the opportunity to get back into the leaders, and watch how quickly they recover.
Role of Money Managers
Another key point about bull markets, said Cramer, is knowing when the fundamentals of individual stocks get trumped by the fundamentals of the money management business. He said when the bulls are running, it's often the money managers that create a self-fulfilling prophecy.
Cramer said big mutual fund and hedge fund managers don't play the same game as the individual investors. While individuals are trying to make as much money as possible, big money is just trying to make more than their peers. So when the markets are up big and money managers are caught on the sidelines, or worse, are short the markets, the fear becomes almost palpable.
Cramer said when the markets rally a few percentage points, these managers can usually make excuses and brush off the move. But when a rally hits 10% or more, the gloves come off and money managers are forced to buy in or be seriously left behind. If funds don't catch up and rival the performance of their peers, it's their jobs, said Cramer.
So what's all this mean for the average investor? Cramer said it means that once a rally hits 10% or more, they often become self-fulfilling prophecies, as the lagging mutual funds and hedge funds, in moves of desperation, pile onto the the stocks that are working, hoping for a quick move higher.
Breadth as a Guide
What defines a bull market? It's more than just the averages, said Cramer, its breadth. It's not enough to just look at the
Dow Jones Industrial Average
, he said, because those averages don't tell you the true state of the markets. He said its breadth, the number of stocks advancing versus declining, that's the true indicator.
Cramer said to think of breadth as a polygraph test for the major averages. A broad market rally with lots of stocks headed higher is telling the truth, while a thin rally, with only a handful of companies surging, is definitely lying to you. "A broad market rally is one you can believe in," said Cramer.
There is precedence for this, said Cramer. The rally of 2007, the one right before one of the worst market declines in history, was totally false, he said. That rally was incredibly thin, being led by just the fertilizer stocks, along with natural gas and mineral companies. All of these sectors, said Cramer, were being fueled by skyrocketing commodity prices, and nothing else.
The rally in 2009 however, is a different case, said Cramer. That rally started thin, with only a few semiconductor stocks, banks and the oils leading the charge. But shortly after that rally began, it grew to include the rest of those sectors, then other sectors, followed by others. It's this increasing breadth, said Cramer, that tells investors the rally is for real.
Using breadth as you guide, said Cramer, you'll be better able to know when the market's lying to you and when a bull market is the real deal.
While a rally's breadth can help investors to see the market's true colors, Cramer said technical indicators, often do the opposite and can bring investors to ignominious defeat. He said that in extremely bullish or bearish markets, indicators such as overbought/oversold oscillators often break down and lose their predictive capabilities. Using them, said Cramer, will cause investors a lot of pain.
According to Cramer, most of these technical indicators assume normal market conditions. In the case of oscillators, they assume that once a stock is beaten down hard and has move too far, too fast, it's poised for bounce back. But in extreme markets, like the crash of 2008, stocks fell, and kept falling, rendering these normal metrics useless.
Likewise with the rally of 2009. While most indicators and oscillators were telling investors to sell in April, stocks continue to roar higher, as demand from big money managers finally outstripped supply.
Cramer said the same principles apply for other indicators, like put/call ratios. In extraordinary times, he said, they simply cannot be relied on.
No good thing can last forever. So once investors know how to spot a bull market with its leaders, gauge its strength using breadth, and can predict the moves by money managers while avoiding the pitfalls of technical indicators, the last thing they must do is know when its coming to an end, said Cramer. The No. 1 killer of bull markets, he said, is inflation.
Inflation is a serial killer of bull markets, said Cramer. He said that every bull market depends on the
and low interest rates, so you never fight the Fed when it's raising rates and taking a tightening posture. When the Fed smells inflation, said Cramer, everyone suddenly gets scared that their earnings will disappear, and that's the beginning of the end.
The second killer bull markets? Super-extreme valuations. He said when markets stop valuing stocks based on earnings per share, and instead start using eyeballs or page views, or takeover values, that's the time to start worrying.
Cramer said yet another killer of bull markets is unemployment. He said no bull market can sustain itself without jobs. He said the markets can go for stretches with weaker employment and firings, but an unemployment rate above 10% is almost always a bull-killer.
Finally, Cramer said bull markets are killed by the death of its leadership groups. He said that in 2007 and 2008, the leadership sectors began dropping like flies, and when there was no one left to lead, there was no one to follow, an that left the market in a tailspin.
Cramer said before resigning yourself to bull market nirvana, be on the lookout for these warning signs.
-- Written by Scott Rutt in Washington
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Jim Cramer, host of the CNBC television program "Mad Money," is a Markets Commentator for TheStreet.com, Inc., and CNBC, and a director and co-founder of TheStreet.com. All opinions expressed by Mr. Cramer on "Mad Money" are his own and do not reflect the opinions of TheStreet.com or its affiliates, or CNBC, NBC UNIVERSAL or their parent company or affiliates. Mr. Cramer's opinions are based upon information he considers to be reliable, but neither TheStreet.com, nor CNBC, nor either of their affiliates and/or subsidiaries warrant its completeness or accuracy, and it should not be relied upon as such. Mr. Cramer's statements are based on his opinions at the time statements are made, and are subject to change without notice. No part of Mr. Cramer's compensation from CNBC or TheStreet.com is related to the specific opinions expressed by him on "Mad Money."
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