You might be wondering why we need to take a detour to discuss The Sentiment Cycle. Surely mechanical trading is designed to do away with emotions, right?
Yes, a good trading system helps us stay the course and do the right thing. It prevents us from chasing performance, from loading the boat at the top. A good trading system does not allow us to experience the trauma of puking at the bottom after a long downtrend by virtue of using stops and position sizing. A good trading system frees us from our worst fears – the fear of losing, and the fear of missing out.
If you make a bad trade and you have money management you are really not in much trouble. However, if you miss a good trade there is nowhere to turn. If you miss good trades with any regularity you’re finished. — William Eckhardt
Buying high and selling low is not the way to go, but human nature makes it hard to resist doing it because we are simply designed to feel most confident and have the most conviction to act when there is a massive amount of public opinion that concurs with the fundamentals, along with widespread agreement that a big trend in place. Contrarians tend to be way too early, and often experience the old “light at the end of the tunnel is the on-coming train” phenomenon. By and large the typical human “gut” is simply not geared for trading.
Human nature does not operate to maximize gain but rather to maximize the chance of a gain. The desire to maximize the number of winning trades (or minimize the number of losing trades) works against the trader. The success rate of trades is the least important performance statistic and may even be inversely related to performance. Two of the cardinal sins of trading – giving losses too much rope and taking profits prematurely – are both attempts to make current positions more likely to succeed, to the severe detriment of long-term performance. Don’t think about what the market’s going to do; you have absolutely no control over that. Think about what you’re going to do if it gets there. — William Eckhardt
We tend to worry too much about making the trade at hand work out for us as if we want bragging rights or something. Let’s not forget that each trade is inconsequential in the big picture (unless every trade is a loser!), since the goal is to make as much money – over a reasonably long run – with as little risk as possible. If you don’t believe me, read the papers at SSRN on Prospect Theory. One of the best ones was The Diversification Puzzle by Meir Statman.
Because each of us we will conduct many transactions over the course of a lifetime, we can’t get worked up about every single one of them. Some will make money; some will lose money, but if I know that my approach is correct and my methodology is sound, then the only thing I need to do with the trade in front of me is make sure that it will not be the one to put me out of business.
We have to keep the ball moving toward the end zone, but we can’t go for the 90-yard “only in the movies” touchdown attempt every time. Most often, the hardworking team grinds it out play by play – a few steps forward, one step back. Always be defensive. Recover those fumbles.
The Mamis Sentiment Cycle
What we have (in Chart 14 of The Nature of Risk) 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. There are two areas in a typical loop where the market does something that traders describe as ‘churn’ or ‘chop’, and two areas where directional trends are found.
On the upside, the area where churning takes place is in between the Returning Confidence phase and the Subtle Warning phase, after a significant advance has already taken place. This often appears in the form of a head and shoulders top on weekly or monthly charts. By the time confidence returns, the market has already been going up for ages while the retracement patterns become ever larger, each one scarier than the last.
To technical traders, this type of price action tells us that the market is getting tired. Perceived bull market volatility excites investors. They waited forever on the sidelines for fundamentals to confirm that the move up was ‘real’. The coast is finally clear and they jump in with both feet. This phase typically ends with a failure on test of top, and the big, super scary ‘buy the dip’ pullback begins.
BUY THE BIG DIP
The public continues to pour money in, lured by glowing good news and economic data. After the long move up, finding attractive stocks becomes difficult for technical traders and market veterans. Traders chase momentum where they find it. Investors believe that the game is back on, and they are willing to take big risk and buy big dips. This Big Dip usually comes after a failed test of top in the Returning Confidence phase. The Big Dip typically takes price below the 50-day simple moving average and quite often, to the 200-day moving average. This is where ABC Corrections are typically found.
Once it is widely accepted that economic and corporate fundamentals are supporting higher prices, a bell goes off. The bull survived The Big Dip. Those who had previously been afraid now have plenty of reasons — and proof — that it is safe to go back into the market and buy again.
At this point, we detect a subtle change in psychology, a shift from the fear of loss to the fear of missing out, and the appetite for risk becomes evident. Investors buy on faith, bolstered by analyst and media reports projecting the trend to continue. As price rises to new highs, they all scream, “It’s a breakout!” They are supremely confident that the best is yet to come.
The high made in the Returning Confidence phase typically marks the ‘point of breakout’ and becomes an important psychological number. We know this high is where sellers showed up before, and if price should sink below this area, traders and investors might come to the conclusion that the breakout failed, and therefore, begin selling in case the uptrend is approaching the point where it starts to bend.
At some point, all the buyers who want to be in the market have bought, and they stop buying. Smart money begins to take some off the table. The net result is rotation of buying and selling from sector to sector, causing the major stock indexes to stop going up in any meaningful way and price charts to churn and chop. In the old days, they called this ‘distribution’, marking the transfer of stock from smart to dumb money, from strong to weak hands. This area is where a buildup of participants in position to write sell tickets takes place. If price fails to move up or it comes back under the point of breakout, selling begins.
The market fails to go higher, and indeed many of the early leaders have broken down under the 50-day moving average, giving technicians the Subtle Warning. This marks the beginning of the ‘something is not right’ gut feeling, but in the absence of bad news, investors hold on to hope. Not only are they heavily invested in the market, they are psychologically invested in being right and they ignore anything that does not go with their worldview. Indeed, they even wonder aloud why their beloved stocks cannot go up amidst good news, higher earnings guidance and analyst upgrades.
OVERT WARNING TO PANIC
The area of sustained directional trending price action to the downside takes place is between the Overt Warning and Panic phases. There will be some sort of catalyst. Perhaps it is an earnings warning or some point of economic data that leads the crowd to finally clue in that the nagging negative price action they have been watching is the beginning of something big and bad.
The 200-day moving average is broken, and CNBC alerts investors. Everyone knows that the ship is sinking. Those who bought in the churning top realize they are holding the bag and stop buying the dips. Smart money shorts each failing bounce. Stop losses are hit, and margin calls force liquidation. Supply simply overwhelms demand and price action becomes a one-way street.
DISCOURAGEMENT AND AVERSION
After a long price slide, the area where churning takes place is between the Discouragement and the Aversion phase, after a significant decline has already taken place. Often, this appears as a head and shoulders bottom, a cup and handle or a saucer dish pattern. As the public continues to dump stocks, short sellers become bold and bearish. Their views are supported by bad news and poor economic data. Prognostication of lower prices to come is undoubted. This is when everyone knows that the market cannot ever go up again, and that anything, even cash, is preferable to owning stocks.
WALL OF WORRY
While the broad indices are still going down, certain sectors will have bottomed. At some point, everyone who wants to sell has done so, and the selling stops. Low prices and relative value returns, and early buyers with deep pockets begin to nibble at the market. The net effect is that the major stock indexes stop plunging and begins to dribble or moves sideways.
This area is where we find a buildup of participants in position to write buy tickets, producing potential buy pressure. With sellers gone, the market even goes up on bad news. Rallies are labeled as ‘technical bounces’ or are written off as ‘short covering’. Short positions add more on every bounce, confident that lower prices are around the corner. When good news trickles in, it is summarily dismissed as aberrations, subject to revision next month.
AVERSION TO DENIAL
Sustained directional trending action to the upside begins between the Aversion phase and the Denial phase. As the market slowly creeps up, the shorts start to sweat while those who don’t own a piece of the action vow to themselves that they will get in on the next dip that they believe is sure to come. The market continues higher and does not let them in.
More and more bids materialize as buyers show up again while shorts begin to cover. Since there are not many sellers overhead, the move up can be big and fast, and on low volume. If it keeps going, eventually those left behind in the dust have to get in again, and the loop continues.
Take note of the way churning precedes trending as an entire group of market participants are trapped in the wrong direction. Indeed, we could argue that trends can only take place after a large group of market participants have been lulled into believing the status quo will last infinitely. When the reversal finally takes place, the ensuing mad scramble becomes a directional trend.
The sentiment loop neatly summarizes the market and all its associated psychosis in a nutshell. I use the word psychosis on purpose, as it is medically defined as “a loss of contact with reality, typically including delusions (false ideas about what is taking place or who one is) and hallucinations (seeing or hearing things which aren’t there).” It is the only way to describe the things that people do at the tops and bottoms. It is similar to how some people break with reality when playing games such as Dungeons and Dragons, and their existence enters another realm. What we must do is to know where we are on the map at all times and maintain a separate sense of self by standing on the outside as impartial observers. That is the only way to preserve sanity and to make money.
To succeed in the long run, we have to become Zen Masters in the financial media circus. We pay attention to our own work. We conduct our own research, and when the market experiences bouts of mania and depression, we examine it with a practiced clinician’s approach to working up a patient – assessing blood pressure, pulse, bloodwork and the like to determine the state of the patient’s health.
Because there are clear phases in the sentiment loop, we need to know about them in order to determine the “what” and “when” to buy and sell. Each of us can make certain policy decisions. In my opinion, the Discouragement and Aversion phases are best spots to buy for position trades while the area between the Buy the Big Dip to the Overt Warning phases are clear signs to lighten up long positions. A swing trader might be more inclined to look at other phases for appropriate opportunities.