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Sunday, October 12, 2008

Capitulation & The Investor Sentiment Cycle

This weekend, some investors and traders will be wondering if we've seen the "Capitulation" stage in the US markets. They are interested because of the belief that after capitulation, markets will bottom and reverse. They will remember past times when stock markets crash, only to bounce back strongly the next day or week.

Wikipedia is surprisingly up-to-date. http://en.wikipedia.org/wiki/Stock_market_bottom - See the section under "2008 Market Drop", where the table is up-to-date as of Friday closing. Note the huge volume in the S&P 500 on Friday, October 10, 2008.

Wikipedia also reported responses from "experts" which is surprising in its up-to-date-ness:

Jim Cramer, founder and owner of TheStreet.com and host of the CNBC show Mad Money, expressed his view on October 7, 2008 that "we are nowhere near a bottom". He said that "three things that need to happen before a bottom in tech can occur. First, the earnings estimates for these companies need to be cut repeatedly until the companies can beat them. Second, companies with bulging inventories need to work through those inventories. And finally, the economy needs to turn around."

Ed Yardeni, of Yardeni Research stated on October 7, 2008 "I'm not sure, but that sure seemed like capitulation yesterday ... stocks are cheap, with the S&P 500 trading at a mere 10.8-times estimated earnings".

The technical analyst Jeff deGraaf
stated "we’re only in about the 5th inning of the downturn." He said "The total number of new companies making 52-week lows has reached 57% .. usually when the number crosses 50% it signals a wash-out... Right now we’re 250 days into the bear market. Typically a bear market runs about 600 days."

Mark Hulbert on Oct. 7, 2008 pointed out that the Hulbert Stock Newsletter Sentiment Index (HSNSI), as of Monday evening, stood at minus 33.5%. As of immediate past Friday's close, in contrast, the HSNSI stood at minus 36.1%. This slight rise suggests that capitulation has not yet occurred
.

Vanguard Group founder John Bogle
stated on Oct. 8 2008, that "the stock market bloodbath is probably more than halfway over".

In an interview at night on Oct. 9 2008, Jeremy Siegel
expressed the view that if libor rate goes down to 2%-1.5%, it will result in a huge rally. He suggested a turnaround in the afternoon of 10 Oct 2008 is possible, although one can never be certain.

Blackrock Vice Chairman Robert Doll said on early morning of 10 Oct 2008 "Often you see double, triple normal volume and we've just not seen that kind of capitulation yet"
. However later on 10 Oct 2008 high volume was reported. "Nearly 1.1 billion shares trading hands by midday, close to half of what most experts consider enough for capitulation."

Based on a small sampling of "expert" comments above, it seems they are "not sure", and a couple thinks "maybe". In short, even amongst experts, there seems to be quite a rather huge doubt.

What about the Sentiment Cycle? Are the charts similar to what the Sentiment Cycle theorists advocate?

I've digged up a 1 year old article by Teresa Lo from invivoanalytics.com here - http://invivoanalytics.com/2007/12/07/the-sentiment-cycle/

The main chart is below:



The 8 stages are:

1. RETURNING CONFIDENCE
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.

2. 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.

3. ENTHUSIASM
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.

4. DISBELIEF
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.

5. 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.

6. 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.

7. 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.

8. 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.


The Big Question is of course where are we right now, after last Friday's Big Drop? It's obvious we're a long way past Stage 5A (Overt Warning), since the 200-day Moving Average have been crossed since the start of Jan 2008, although, the US markets did attempt to cross the 200 day MA again in May 2008, and failed.

Last Friday appears to be Stage 5B (Panic), since it is characteristic with the large volume accompanied by the big drop and recovery attempt later that day.

And since we haven't yet seen the rebound, we have yet to witness Stage 6A (Discouragement). For that to happen, most will expect to see a rebound first, followed by a new low that is lower than what we've seen last Friday.

Perhaps, this is why many of the "experts" think that we haven't found bottom just yet.

My own view is close to the above. However, I have some concern with some observations from other markets. Suffice to say that the patterns observed from US markets last Friday is somewhat similar but inconsistent in some detail with patterns that I observe from other markets (and not necessarily limited to just stock markets).

In short, I expect many of the savvy traders to be looking to enter the stock market for some quick trades, and I would also be looking at confirmations in the various markets that I monitor, but for investors who wants to buy and hold for a long time (with time-frame measuring years), then, I don't think now is a time for "buy and hold". In fact, I would seriously advise traders to forget "buying and holding" during periods of high volatility like now. Buying and holding works great in a bull run, but the present markets is anything but a clear bull run.

In short, I expect next week's strategy to be one of earning some pocket money, but not the serious money yet. That time will come later.

Above all, never ever compromise your stop losses. The difference between winners and losers is a thin but critical line, in that winners can cut their loss when the trend changes, losers hang on to their losses, only to average down and suffer even greater losses. Don't be a loser, be a winner! (And if in doubt, there's always nothing wrong to stay in cash and earn F.D. interest).

Good luck.

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