August 2nd, 2010

Healing Damaged Investor Psychology

There’s so much conflicting and contradictory information that investors don’t know whether to sell or to back up the truck and load up? For example, In a recent Seeking Alpha blog article entitled “Warning Signs Suggest Market Headed for Another Collapse“, the author compared the head-and-shoulders formation in 2008 just before the Financial Crises Crash of 2008-09 to one he sees in the recent market action (something I wrote here often about). He concludes:

a head & shoulders formation is arguably the most bearish technical formation in the books. The time, breadth and size of this head & shoulders is exactly the same as what we saw in early 2008 just before entering the biggest bear market in modern history. The neckline on this formation sits at around 1040 on the S&P 500. A substantial break below 1,000, the low of this current correction, could spell disaster for the broader markets ….. The long-term prospects of the market are completely in question until we see a rally above 1,220 on convincing volume.”

A major fallacy I see in his comparison is that it totally ignores market life cycle and investor psychology. Remember the two charts I frequently inserted last year depicting the various psychological phases the market goes through during its life cycle?

I look at these schematics and ask myself “In what sort of frame of mind are most of “talking heads” today as they give their views, concerns, strategies or advice?” Are they euphoric about stocks today? Are they thrilled with the opportunities they see in the market today? Are they filled with optimism and excitement at the market’s prospects?

If they are they would be tell tale signs that the market is approaching a top, on the verge of a collapse. This is how the big money guys spin their spiel so they convince the little guys to get into the market so they can distribute to them stock they accumulated a long time ago at much lower prices.

I just don’t see that happening and I don’t feel immersed in that sort of psychological atmosphere. Rather than excitement, thrill or euphoria, I sense more of the same sort of anxiety, depression, hope and even despondency resulting from continued uncertainty and fear that is associated more with bottoms than with tops.

We all know that the market hasn’t done anything for almost a year (actually, since last August or 11 months). How flat has it been? Here are the changes from the end of each of those months to last Friday’s close. The table shows the sort of percentage change investors would have realized had they invested at the end of each month and held through Friday’s close:

That sort of performance sure doesn’t look like a top to me. There hasn’t been a blow-out rise, a throwing of caution to the wind. Instead, it’s looked like a consolidation (or base, depending on where you start counting) with the market transitioning from relief that the bottom has been put it to optimism of possible renewed growth. It feels like the end of an accumulation phase and the beginning of the mark-up phase.

Yes it’s taken a long time but the trauma of the Financial Crises Crash was severe. We can talk about interest rates, bottom line vs. top line growth, balance of trade and other currency issues. But bottom line, there’s also a lot of damaged investor psychology involved and that psychology requires a lot of time and therapy to heal.

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  • Anonymous

    GURU–I have been an investor since 1971..Seen Bulls and Bears just like you have..The game has to be rigged solid hard down by now..Harry Browne did a good thing with the PRPFX Fund..At least you wont lose over 20% and have to kick cans down the road when your 65 yrs old..God bless America ?? No thanks ,,God bless Harry Browne and the IRA account..

  • Joe

    You said a lot but I'm not sure what your point is? What do you mean "game has to be rigged solid hard down by now". What makes the Bull and Bear markets you've seen over the years since the 1970's any more rigged today than they were at any other previous time?

  • Jesus_is_Lord

    I cant speak for anonymous, but I too think the market is rigged more so than in the past.
    You have high-frequency computers in front of "regular" computers, and able to intercept orders etc.
    You have "too big to fail" IB's able to borrow at almost 0%, make risky bets; and, if they win, keep their profits; if they lose, we taxpayers get to pick up the tab.

    I think Congress (both parties) is in the pocket of Wall St. and the IB's; and now you have the SEC exempt from Freedom-of Infornmation requests, so they can do what they want (or, more precisely not do anything (except watch porn on their office computers.)
    I'm sorry, and this is nothing against you – because I think you're one of the best technicians, and you freely post this blog – but how can anyone put credance in trends etc. when the averages can be painted at will?
    End of rant (again, not against you).

  • Anonymous

    I'm hoping you share your perspective on the 3rd peprson's comments.

  • Jesse

    From JPMorgan:

    The assumption that the Bureau of Economic Analysis had made regarding factory inventories in their initial estimate for Q2 GDP was a bit off the mark, and it now appears that growth last quarter was closer to 1.7%, rather than the 2.4% reported last Friday. (Of this downward revision, 0.1%-point came in yesterday's construction report).

    Inventories at manufacturers of nondurable goods decreased around $4 billion in June, rather than increasing $1 billion as BEA had assumed. As a result, it now appears economy-wide nonfarm inventories increased at a $55 billion annual rate last quarter, and stcokbuilding contributed 0.5%-point to GDP growth, rather than the 1.1%-point initially reported.

    With the implied revisions, second quarter growth is now looking especially soft. On the brighter side, the prospect of a big inventory overhang weighing on third quarter production — which loomed large in the initial estimate — now appears less threatening.

  • Joe

    It's easy and convenient to talk conspiracy theory with the market acting as bizarre as it has but I just can't buy into it. Unlike 80-100 years ago when about the only stocks available were US-based rail, oil, car, automobile and radio company stocks, today money flows around the world into all markets and more and more synthetics (ADRs and ETFs) make the "stock market" that much more interesting and fluid.

    I'll take the opposite side of your argument and agree that IB's and high-frequency trading might impact the market and steal a trade from you in the short run. However, in the long run, the only one who might have the resources to impact the market today and moving averages over the longer-term are governments. I dismiss that, though, because we would have already heard about that if it actually has been happening since no one in Washington can keep a secret.

  • Anonymous

    Karl Dennibger would disagree with you:

  • Joe

    I transcribed Denninger's spiel verbatim because I wanted to read it and understand exactly what he was saying and, as far as I can see, it's a bunch of bull. His major premise is

    "folks, let me make this clear, for everyone that is a winner in the stock market using these kinds of games, which are all these high-frequency trader guys, the algorithm owners, the firms that are using these computers, there's a loser. For everyone that wins in the market there is someone who loses. The only exception to that is in an IPO when new capital is raised or when a new bond is issued. When you're trading for every dollar you make, someone else loses a dollar or they forgo making a dollar. That's just how it works."

    But the stock market isn't a zero-sum game … it's a market. In each trade, there's a buyer and a seller. No one is being forced to execute a trade at any price. And if you're making a trade based strictly and exclusive on the stock's bid and ask at the moment you place your order then you're the being short-sighted and foolish.

    Your trade should be based on the flow of many orders, over an extended period of time. You should try to determine whether your order when you place it is consistent with the flow of momentum for the market, the industry group and the individual stock.

    Momentum isn't defined by an instantaneous bid and ask but by investor psychology over a day, week, month or quarter. You may wind up paying a dime more or selling for a quarter less for a stock but that shouldn't make the difference between a profitable or unprofitable investment.

  • Jesse

    personally I'm interested in knowing what it is that's making you so bullish? You have a bias towards being bullish. are you looking only at the MA's and ignoring the data and the economy? are we ignoring the coming tax hikes? There are so many warnings of bad things to come. I just can't even begin to understand why one would be bullish right now. We're in no mans land with a test at the shoulder of 1145ish possible.
    And I'd have to agree that there's a lot of manipulation going on in the markets. GS is one example who only got a slap on the wrist. There's lots more out there. even with the fin reg bill, fannie and freddie are left out. it stinks to high heaven. The Fed is artificially holding the rates at zero. the list goes on and on, but if your bias is glass half full that's how you'll see things. good day Joe

  • Joe

    The technical indicator I look at mostly are the four MAs (50,100,200 and 300). I next look at horizontal trendlines (resistance and support). I'm not smart enough to gather, distill and evaluate the meaning and ramification of all the fundamental news out there … I'll leave that to the pros. I spend my time trying to figure out whether the majority of them are buying or selling.

    I guess the upward bias in the market recently has made me somewhat more bullish. I'm not going to go all the way though (now just over 55% invested) until a successful and meaningful (i.e., high volume) cross over 1165. I see that becoming more and more a possibility around Labor Day as the outcome of the mid-term election becomes clearer and it looks like the Republicans gain some control of the purse strings.

    That's how I see it now. Sorry if that disappoints you.

  • Jesse

    "Republicans gain some control of the purse strings." when that happens, there will be no more of this artificial propping up the markets are loving right now. The government has been the biggest job creator and spender the last few quarters. Joe, what happens when the government stops spending money? What happens when the average taxpayer sees the largest tax increase in US history? which direction will the gdp go when that happens? You don't need to be a pro to go down the logical path to conclusion.

  • Jesse

    I honestly hope you're not saying that you're not smart enough to figure out what happens when tax payers see the largest tax hike in american history or what happens when spending stops. If more of my money is taken by the government, that means I have less to spend. consumer spending = 70% of gdp. You know that. There's more to trading than MA's. But, your answer helps me understand why people are buying the market. I still have not figured out how to bury my head in the ground, turn off common sense and reality and blindly buy the market. One day, maybe I'll get there 😀

  • Anonymous

    This discussion is very interesting, bit I'd like to go back to the question, Joe, you posed to the first poster about markets being more rigged today than in the past:
    It's a fact that firm like GS are doing High Frequency trading, using super computers at the front of the line.
    You didn't like Denninger's words, but what about the proof that he and others have come up with to show that markets are being goosed up and down with phony buy and sell offers that aren't meant to be executed.
    That might explain how GS and the other IB's have reported quarters where 100% of their trades were successful. What's the probability of that in a non-rigged world?
    I could go on, and I am not meaning to rail against you, Joe.
    My investor psychology is way beyond damaged. I'm outraged that what amounts to a "legalized" transfer of so much of the nation's wealth is allowed to go on.

  • Joe

    There are only two times when I look at "rigged" bid and ask prices or what is called "phony sales". When I place a buy or a sell order. I know what I want to pay for the stock and that is a price based on previously closed transactions. My limit order executes only at that price.

    I do have a complaint if some trades are made "over the counter" so to speak and don't, therefore, make it into the transaction volume data. If there's anything that should be outlawed and stopped, it's that.

  • Joe

    One last comment.There is one complaint I have and that's the way people who are dissatisfied with their market performance find a scapegoat in what they consider to be a "rigged" market.

    Perhaps it hasn't been as easy to make capital gains at 10%+ over the past ten years as it was in 1980-99 but it will again sometime in the near future (I think it begins after the market crosses that 1165 threshold).

    I would venture that similar arguments were being voiced during the frustrations of the last secular bear market of the '70's. Be patient, this too shall end.

  • Jesse

    joe, you avoided my questions like the plague. The anon blogger is correct about GS posting nearly 100% profits on trades. No one is that good. The PPT was created in 1988 and has continued to prop up the markets since then.
    I'll give you a pass since it's your blog, but I'm growing tired of more and more people who are unwilling to take a look down the road to the obvious logical end of this reckless governments policies. hey, maybe we get a double top. but the truth is our economy is in deep trouble and you cant just print money and continue to do into massive unsustainable debt. there are consequences to such recklessness and they are coming.

  • Anthony

    Jesse, I don't think anyone is disagreeing with you (at least I am not). I think what Joe is ultimately saying/promoting is that by anticipating the trends/sentiment of the market in the intermediate, he is employing a specific set of rules to cash management. At the point things start to crumble and positive sentiment turns negative, by divesting ones investments according to these rules, one is in an all cash position when everything goes to hell. Am I understanding the general principle correctly? Ultimately it is irrelevant whether the market is propped up by governments, computers or Santa Claus, whenever those devices are taken away, the market should react in a specific way and the cash management system should kick in.

    I guess the danger is that it all happens in about 5 min and the Dow goes to 1000 with no time to be concerned with a MA. I'm guessing if that happens we should probably be more concerned with buying as much canned food as possible for the coming Armageddon.

  • Anonymous

    It's all about the technicals and the equity markets looking forward. I hope there are more of you bears; as I've said here before that the bulls need this wall of worry. The shorts will be squeezed and the retail investor who is doubtfull now will need to buy in this bull market. I think the market is looking at now is a Congress similar to the Clinton's Congress of 1995 and a renewed Republican contract. Finally this will put an end to Obama's era (Hillary is gloating). Also remember this is a global economy and feel that companies that are positioned that way will move up. SP500 at 1295-1350 by EOY. All you Bears are "bulls". And austerity is around the corner.

  • Jesse

    it shocks me every time I hear someone try to make a case for a bull market. to each his own, happy trading

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