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Library Home Street Smart Report Home
BEING STREET SMART
by Sy Harding
The
Importance of Investor Psychology!
Subscribers know from reading Riding the Bear, and frequent comments in the newsletter and hotlines, that investor sentiment is one of the surrounding conditions we find very important in indicating an approaching turn in the market.
To paraphrase a paragraph from Riding the Bear: Page 92, Titled 'Ignore the Crowd!';
"The first thing to take from the historical data we're going to explore is that the investor sentiment that accompanies market tops, and correction bottoms, is almost always diametrically opposed to the direction the market actually takes. As we learned in previous chapters, investors and analysts tend to extend the latest trend in a straight line into the future, expecting it to continue, and the longer it does, the more convinced they become that it will continue. So following the prevailing crowd psychology at rally tops and correction lows will never prepare us for a change in market direction. In fact, at important turning points it would almost always have us on the wrong side of the market, which is why investor sentiment is known on Wall Street as a 'contrary' indicator."
In other words, as a rally gets underway and investors pile in, their profits begin to pile up, and they become increasingly more excited and optimistic. So it's not surprising that by the time the rally has run long enough that the market has become overvalued and due for a correction, investor enthusiasm and bullishness has also reached an extreme, and they will find it hard to recognize that the inevitable turning point has been reached.
In the other direction, when a correction gets underway, if it becomes serious, investors will become increasingly fearful and bearish as prices continue to fall. So by the time the correction ends, investor fear and bearishness will have reached an extreme, making it difficult to recognize the buying opportunity.
Investors are spurred on to those extremes by a similar reaction in the media. When rallies are underway, the media becomes increasingly excited and bullish, with the result that near rally or market tops, nary a discouraging or cautionary word is heard. Each day brings reports dominated by stocks that are making new highs, and interviews with the most bullish of money managers and Wall Street spokesmen, with skepticism aimed at anyone with a cautionary warning.
At the opposite extreme, by the time a correction has run its course, and losses have piled up, the media has become extremely negative. Its reports and commentaries are dominated by news of the stocks that have collapsed or are making new lows. Its choice of interviewees are dominated by those with bearish forecasts. And skepticism is aimed at anything presented as having potential to create an upside reversal.
You need only think back to this past spring. Investor euphoria and bullish sentiment for the Nasdaq as it soared past 5,000 became extremely high with investors and the media. Buying on 50% margin reached levels, etc. When our technical indicators gave a sell signal on the Nasdaq and we recommended selling it short with a downside target of 3500, we received the most mail ever, including from those in the media, indicating that we were going to be wrong this time, because can't we see how powerful the uptrend is. But the optimism and euphoria did mark an important top.
Then, during the subsequent August rally, investor bullish sentiment again reached high levels (and margin buying returned to record levels). There was again great reluctance to believe the sell signal on our technical indicators and our recommendation to sell the Nasdaq short again, or that we could be right in predicting a resumption of the downside for the entire market. Because the rally had made investors optimistic again.
But that bullish sentiment has now taken a nose-dive after the subsequent September/October correction, and is beginning to approach bearish and pessimistic levels usually present at important correction lows. For instance, the CBOE Put/Call Ratio has risen to 0.82 as the usually wrong options players are now betting heavily that a market correction lies ahead, just the opposite of their outlook at the August rally peak.
So, we are watching the investor sentiment readings very closely along with our technical indicators, as both seem to be setting up for the significant low and buying opportunity in the October/November time-frame.
But, don't jump the gun. Our intermediate-term technical and fundamental indicators remain on the sell signal, and our short-term indicators continue to tell us the short-term is perilous.
However, it looks like investor sentiment, or crowd psychology, will again be very negative towards the market at the eventual bottom when we expect our next buy signal. Something to keep in mind.
