The Emotion Cycle Part Two

I've often taught in my classes that a price chart is not about prices, support, resistance, etc as it is in understanding the unchangeable aspect of the market called human nature. When you can look at a chart and put yourself emotionally in the moment, you better understand the market sentiment and valuations are not what drive the market, not alone any way. Sentiment is what drives the market and perceived valuations, etc. This is also part of the reason the market is like a pendulum that swings way too far in one direction and then reverses and swings too far in the other direction. The failure of technicians to understand market sentiment has led to the simplistic thinking like "price crosses the 50-day average means I should buy". The 50 day average and price crossing it are useful and meaningful, but the underlying sentiment that created the move in the first place is the more important aspect to understand. Think back to some of your own emotional experiences and try to put yourself in the "sentiment mentality" when reviewing price charts. Once you do that, you will gain a much more comprehensive view of the market. Even with robots trading the market in record numbers, their algorithms are still a construct of human sentiment.

Once again I present the emotional cycle of the market.

Now we must try to identify where we are in this emotional cycle to better understand where we going next. This applies to a single stock just as much as the S&P-500.

We know that a few things are happening, insiders are selling at record levels. We know that traders are trading on the heaviest margin debt burden we've seen since September of 2008 just as the market began it's 50% bear market plunge. We also see new money finally entering the market after nearly a year of money outflows from the market.  We have many other indications that I have put out there and you can piece them together.

And now just released, we have Merrill Lynch reporting that fund managers are now more bullish then anytime in history since the survey started in April of 2001. 67% of mangers had an overweight on global securities meaning many of them are using a high degree of leverage (debt). This is up around 27% since just December 2010. Those on the other side of the sentiment of the survey accounted for 9% maintaining an underweight position on equities which is the lowest since 2002 when we were still in decline and starting to bottom out after the tech bubble implosion. Clearly sentiment is leaning heavily to the bullish side which is dangerous. Yet many traders will take this as a sign they should "Trade the trend" which to a degree is true, but the gross neglect in such a high level of sentiment plus such a high level of leverage being used is negligent.

As I've said, there's nothing wrong with trying to follow the trend, but you MUST realize where you re in the sentiment cycle, lest you take a massive hit when the music stops playing.

Human nature as it is, takes quite sometime to recognize the music has stopped playing and by that time they have incurred substantial losses and the new thought becomes the new trading principle, "I'll sell when price gets close to my break-even point" and in a bear market decline, that rarely happens. The final event in which the masses of sheep finally admit their mistake is called, "Capitulation" and ironically it is also the point in which the market has pretty much bottomed out.

So if you take anything away from this, I hope it is the following: Learn to look at price chart's action as an indication of emotions-(i.e-Fear or Greed; Fear or Complacency). Also that you realize the markets in the end, are driven by human emotion (even when we get bouts of manipulation like we see with the Fed), when we look back at this period several years from now you will see the emotional cycle play out. Lastly I hope you understand that loyalty is reserved for your friends and family, not for a stock. Even and especially when it's made you a lot of money, when the party is over, it's over and you need to be able to treat an investment as exactly that and do not fall in love with stocks that have treated you well in the past. As the Buddhists say, anything close enough to comfort you is close enough to hurt you.

We are seeing the extremes of sentiment, however as I mentioned, the market is pendulum like and these extremes can carry on quite a bit longer then you might imagine. The simple answer for that is risk management and looser stops (with fewer shares) when we get into a volatile topping/reversal situation.