How to View the “Sentiment Cycle” on a Chart

04/07/2010 12:01 am EST

Focus: STRATEGIES

Graham Neary

Technical Analyst, FuturesTechs

The first speaker on the Society of Technical Analysts (STA) annual diploma course—at least for the last few years—has been Julian McCree, who always extols the idea of market sentiment, and in particular, the sentiment cycle, a theory developed by Justin Mamis, author of The Nature of Risk, Stock Market Survival, and The Meaning of Life.

Someone once said to me, “The Market is a mechanism for messing as many people about as it can, as often as possible.” Sounds a bit cynical, but I believe a firm knowledge of the sentiment cycle and an understanding of where we are within the cycle could help us guard against being messed about and give us a clue as to where we’re heading—like a road map.

Justin Mamis sums up nicely what the sentiment cycle represents in saying: “What we have is essentially a graphical representation of the manic depressive moods typically experienced by market participants as a function of time and price in one complete sentiment loop.”

See the chart below, taken from Mamis’ book, The Nature of Risk.

chart
Click to Enlarge

Let’s take a quick glance at the different phases and the market psychology behind them.

Returning Confidence

By the time confidence is fully restored, the markets have been rallying for some time. They start to get choppy and retracement moves get consecutively more fierce, each one more intimidating than the last.

Buying the Dip (The Big Dip)

A huge pullback now gets underway, even larger than the scary one you may have witnessed last month or so. After such a dynamic bull run, investors are willing to take on a phenomenal amount of risk, and the smart money buys the big dip. Also, money is still flooding in from the general public, who likely read in The Sun that stock markets will remain strong for all eternity.

Enthusiasm

At this stage, all economic data still supports the idea of higher prices. Traders who didn’t get involved in the last-dip buying opportunity now have hard evidence that it worked before. All of the traders who wanted to be long are now long (there are no more buyers), causing prices to decelerate. Distribution starts to take place, i.e. stocks transfer hands from smart money to stupid money—strong to weak.

Disbelief

Traders start to get that gut-wrenching feeling that something may be changing, but the fundamentals still don’t back this up, and people cling onto hope alone. Analysts start to get subtle warnings. Maybe previous market leaders start to break below important support levels or moving averages.

Overt Warning/Panic

Typically there’d be a catalyst here (i.e. big banks like Lehman Brothers start to file for bankruptcy… sound familiar?). The index will break below a previous reaction low or maybe the 200-day moving average. News readers will be telling the world that the fun is now over. Intelligent investors start to sell rallies, giving stock prices little or no chance of any recovery.

Discouragement and Aversion

Prices have been rattling off for some time now as the general public starts shedding stock and the short sellers are stronger than ever. There’s no good economic news flow and everyone thinks that stock markets will go down forever.

Wall of Worry

Certain market sectors will now start to bottom out as everyone who wanted to sell has done so. The smart money now starts to move in slowly, resulting in the market pausing for breath or drifting along sideways for a few months. There are no sellers left; so despite the bad news flow, markets start to creep higher. Short sellers start to cover their positions, adding fuel to the fire.

Aversion to Denial

Markets start to trend upwards. Short sellers start to get concerned that sentiment has changed. With no sellers above the market, these sorts of moves can be fast and sharp and tend to leave people behind.

By Graham Neary of FuturesTechs.co.uk

Related Articles on STRATEGIES