Sunday, September 21, 2008

TTT : THIS IS HOW THINGS SHOULD GO !!!

Let's start in the depths of a bear market. The economy is usually in a recession or worse, business profits are tumbling and investors are punch drunk from suffering huge losses during a year or two of falling prices. Bad news is making headlines; good new is not even a dream at this point. Conditions have been so awful for so long that most people can see nothing else but the downtrend continuing. It's amid such doom and gloom that bear markets bottom and bull markets begin, meaning that the vast majority is wrong, precisely at the bottom.

Why? Well, with the economy collapsing, the Federal Reserve will usually begin loosening credit, and interest rates will start to fall precipitously. This gives stocks additional value as the competition from yields on cash equivalents falls. Typically, though, the economy has another six months or more left on the downside, and the worst results for corporate earnings usually lie ahead.

Even if Wall Street is correct in anticipating these lower profits, it can hardly equate them with higher stock prices. There seems to be some inborn reasoning in Wall Street that better profits mean higher stock prices, but this simply is not true in the aggregate. The best gains made in bull markets tend to come in the first six months of a fresh bull market, when profits are usually declining. So, it's difficult for investors to be optimistic when they're staring at a terible outlook for corporate earnings.

At this point investors and speculators have built up extraodinary cash reserves on the sidelines, partly because of the higher interest rates during a bear cycle and partly because the outlook is so gloomy that they prefer to hold cash rather than stock. Individuals and institutions have high levels of cash and little or no willingness to purchase stocks. Pessimism reigns. But when rates start to dcline, that acts as a catalyst in generating buying power because cash coupled with lower rates is not as attractive as cash coupled with higher rates. Moreover, the sharp drop in interest rates will usually stimulate the economy six to twelve months down the road. The stock market is a discounting mechanism, always looking ahead. So the current profit scene is not nearly as important as that anticipated.

With declining rates the usual stimulus, prices begin to rally as a new bull market is born. Not only is there tremendous pessimism before this initial rally, but that first rally traditionally is not believed! ARE WE HERE? During bear markets several rallies start, only to bite the dust, thus leading to lower and lower prices later. So why trust the new rally in the new bull market, especially since it tends to be the most vigourous rally seen in the cycle? The thinking is that if prices rally even more than usualy in a short period, they have that much more to fall back.

So, the shrewd investor, going against crowd behavior, has two clues near a bear market bottom: first, extraordinary pessimism among the crowd at the bottom, and second, continued skepticism and pessimism during the fist sharp rally in the bull market. In bear rallies the pessimism usually fades rapidly since investors are very eager to want to believe in the rally, hoping that the old bull market is resuming. But at the bottoms of bear markets, the crowd has been hammered too many times and regards the first true rally in the new bull market as an opportunity to sell. The crowd tends to be wrong at exactly the wrong time.

As a bull market proceeds and the rally fails to give way to a major decline, many investors find themselves shut out. Slowly they begin to believe that the move might be for real, and the thinking is, "I'll buy on the next decline." The problem is that the declines are never large enough to make people feel comfortable about buying. That's because there are too many bears on the sidelines eager to get in.

When prices back off just a couple of percent, several of these bears begin to buy, prematurely ending the decline and not allowing the bulk of the bears the opportunity to buy at lower prices. This trend continues as the market goes higher and higher with only small sell-offs. Eventually, the number of bulls becomes greater than the number of bears and, to some people studying the behavior of crowds, that becomes a signal to sell.


The idea is that if you use contrary opinion, you should go aginst the majority. But that's an oversimplification and certainy not true in the middle of a bull market. Just because 51% of the crowd is bullish and 49% bearish is no reason the market cannot go higher. In fact, it probably will advance at that point. The time to be wary of crowd psychology is when the crowd gets extraordinarily one-sided.

As the bull market continues to move higher, more and more people turn bullish. The flash point is really hit when the crowd has gotten so optimistic that it has used up the bulk of its cash. Cash represents firepower in the stock market. When it's depleted, the ammunition to blast stocks higher is gone. About the best the market can do is hold the line. If interest reates climb or some other undesirable fundamental factor appears, the market would be in serious trouble if the cash levels were low.

Near the top of the market, investors are extraordinarily optimistic because they've seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and rose to loftier levels. The crowd anticipates higher price, and it "knows" that even if a sell-off comes, it will only be another buying opportunity and eventually will lead to still further advances.

At the top, optimism is king, speculation is running wild, stocks carry high price/earnings ratios, and liquidity has evaporated. A small rise in interest rates can easily be the catalyst for triggering a bear market at that point. On the first decline, pessimism does not pick up very much. Remembering the lessons of the bull market, people rush to buy on the decline, figuring that prices will bounce right back to new highs. But the first rally falters, doesn't get very far, and fails to make a new high. The next decline comes and carries prices even lower.

Now people begin to get a bit nervous and the pessimism slowly rises. It takes numerous sell-offs over many months before the pessimism really picks up speed. At some point in the midst of a bear market, business conditions are terrible. Then we're right back to the beginning of the cycle at the bottom of the bear market, when pessimism is at a peak.

Some people call the idea of monitoring the crowd and going against it the art of contrary opinion. It's okay to use that term, but just remember that you don't always want to go contrary to the crowd - you only want to do so when the crowd is extremely onesided. It's not easy to define extremely. There are many ways to measure the sentiment of a crowd, but the exact percentage of bulls or bears on any one indicator needed to give a buy or sell signal varies considerably from cycle to cycle. There is no magic level of optimism or pessimism that gives precise signals. That may be frustrating but it's a fact of life.

Nonetheless, by measuring a significant sample of crowd sentiment, ranging from the cash positions of individuals and institutions to the amount of speculative activity in short selling or option trading or the purchase of new issues, you can get a rough gauge of the degree of optimism or pessimism prevailing. When the crowd does get extreme, you should at least be wary. You can then integrate the sentiment readings, as crude as they might be, with monetary and tape condidions and have a fairly good sense of the major direction of the stock market.

Printed by Permission PHD. Martin Zweig

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