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BEFORE BEGINNING AN exploration of the various techniques and methodologies of bear market identification and trading, it is necessary to understand something about the psychology of the market. This chapter will set the tone for the rest of the book in that it will attempt to distil many of the motivations of traders during market swings.

It has always been my contention that trading is primarily a psychological endeavour, and as such we need to understand our fellow traders. Once we understand what drives others to make decisions, our understanding of market dynamics is greatly enhanced. We will know why volume spikes at either the top or bottom of ranges, and how we can use this as a trading tool. We will know when to anticipate a change in market sentiment and how far this potential change is likely to go.

THE BULL/BEAR MARKET CYCLE

The bull/bear market cycle is the broadest definition we can possibly have regarding the cyclical nature of the market. Put simply, the market is initially dominated by the bulls. This is followed by an uneasy interregnum, followed by a swing in sentiment towards the bears. It is obvious that at any one point there will be a successful group, whose market view is confirmed by the current market trend, and an unsuccessful group, whose view is contrary to the trend.

Each of these groups will have differing characteristics. The successful traders will be motivated largely by greed, and will tend to congregate in groups with other like-minded traders. This grouping together reinforces the prevailing opinion of the herd, thereby further driving prices in a given direction and further enhancing the success of the group. This is largely why trends, when started, continue: they exist on a limited-feedback loop that is reinforced for an indefinite period of time. If you want a practical example of this, take time to visit the market display area outside one of the exchanges. During bull markets, you will notice very large congregations of amateur traders – in effect a small, rather directionless herd. Take time to watch the reaction of the crowd. The mood is generally buoyant, everyone is talkative, and positive opinions about the market are reinforced.

The unsuccessful group – whose opinions and strategies run counter to the prevailing market direction – has a different set of characteristics. Each member of the group is isolated and fearful. The members of the unsuccessful group are somewhat fragmented and disassociated from others. Again this can be seen in the market display area. Generally those by themselves during periods of peak market activity are those with a differing view to the majority. They may be long when it is time to be short, or vice versa. They might be attempting to counter-trend trade. This disassociation from the main group is to be expected. Within crowds, contrary opinions are not tolerated, and only become accepted when the opinion of the crowd changes. Consider the scene outside exchanges when market sentiment swings bearish very quickly. The majority of market participants never consider this to be a possibility. As such, their mood is pensive and withdrawn. There is no celebration, as everyone feels isolated within their own cocoon of fear.

Within any market cycle, there will be those who are successful and those who are unsuccessful. There is no discrimination as to whether you are successful during a bull or a bear market. The characteristics of each group remain the same. The successful move as a group, reinforcing prevailing opinions, and the unsuccessful are isolated and withdrawn.

This leads me to recommend some homework for traders. Spend a few days in the market display area of the stock exchange, observing people and how they react to changes in the market. Watch their facial expressions, their mood and the general level of noise. Such an experience will give you an insight into the psychology of crowds. Consider this little exercise to be the first step in understanding a subject I call “Trader’s Anthropology 101”. If you can gain insights into crowd behaviour, the indicators we will look at later will have more meaning, and they will provide you with a much greater intuitive sense of what is happening in the market.

REASONS FOR PRICE REVERSAL

Trading is about spotting trends as they develop. Trends naturally arise out of price reversals, but the question is: why do prices reverse and new trends become established? The traditional answer to this question is that there is a change in underlying fundamentals, and this change is transmitted into the price. This argument is inherently flawed, since fundamentals often have no impact on price whatsoever, and whatever influence they do have is filtered and distilled by the perceptions of the traders who make up the market.

There is a simpler, more efficient answer as to why trends persist and then change. A trend will continue in a given direction for as long as there are new market participants to give it impetus. Quite simply, a trend will continue as long as there is new money. This is why reversals come at extremes of sentiment. Markets become bullish when everyone is bearish, and vice versa. As an example, consider the following chart.

FIG. 1.1 – MARKET REVERSALS

One point is immediately apparent – market reversals occur as sentiment peaks in either a bullish or bearish direction. In the case of swings from bull to bear markets, the market becomes bearish when everyone is bullish. If you consider this, it is extremely logical. Investor expectations are simply irrational in respect to the potential gains left in a given move. As such, these expectations are easily deflated and are prone to wild swings. Such a development is quite easy for the average market participant to imagine. Consider the last time you had a trade that was profitable. It is most likely that your mood was positive and optimistic. You probably assumed that the move would go on forever. Now contrast this mood with how you felt when this trade started to go bad. Your mood probably swung from wildly positive to the depths of despair. Trading can be an extremely emotional endeavour, and many treat a reversal of fortune as if the love of their life had just left them. This is the behaviour of crowds, and it is replicated in each individual who makes up the crowd.

If you think such behaviour is only the preserve of the amateur trader, consider the following table (Table 1.1).

TABLE 1.1 – “FORECASTING” RECORD OF MUTUAL FUNDS BASED ON CASH-TO-ASSETS RATIO

This table tracks the performance of mutual funds in the United States for the period 1956 to 1988. It analyses the cash-to-assets ratio of the funds, and then uses this as an indicator of whether the fund is bullish or bearish. This investment stance is then reviewed to see if the funds’ predictions were correct.

In a sample period of 32 years, the fund managers got it right on only four occasions, and these four instances can be put down to coincidence. What was found was the funds were most bearish, i.e. fully invested in cash, as the market became bullish, and they were most bullish, i.e. fully invested in equities, before markets peaked. These funds displayed exactly the same irrational behaviour as the majority of market participants. There is no reason to believe that these particular observations regarding fund managers do not apply in Australia.

In returning to the reasons why trends change, there is an even simpler explanation than the psychological characteristics of traders. Trends simply run out of steam when there are not enough new market entrants to sustain a move. Prices reverse when the investment community is fully committed to a given point of view.

This can be illustrated with an analogy. Imagine there is a group of people pushing a car up a gradually-steepening hill. Each time the gradient increases, a new member is added to the team at the back of the car. This would not be a problem if the gradient was increasing at the same rate with which fresh pushers were arriving. Imagine, though, that the gradient is increasing at a rate greater than that with which fresh pushers are arriving. Sooner or later, simple physics wins. The team are no longer able to maintain forward momentum. Their efforts stall, and the car begins to move backwards, despite frantic efforts to move it ahead. These last-ditch efforts can be seen in the terminal phases of price moves, as traders attempt to push prices higher. Such activity shows up as volume spikes, and is referred to as “climax” or “blow off” volume. I prefer to think of it as the bulls going under for the final time.

THE REVERSAL PROCESS

What we have examined so far has provided a broad overview of the behaviour of crowds when markets pivot through their broadest of cycles. The next step is to apply this to a real-world example and to see what sort of insights this understanding can bring us. More importantly, we want to see how this knowledge can help us to be more profitable in our trading.

The chart on the following page (Fig. 1.2) is of BHP, and was chosen because of the sustained bear market BHP endured after attempting to move to a new high. As such, it is ideal for examining the reversal process and how this process influenced traders to change their opinions. This, in turn, changed prices and the prevailing trend.

FIG. 1.2 – BHP REVERSAL PROCESS (1997)

Three points are noted on the chart: the reversal point, the retest and the confirmation of the new trend.

The Reversal Point

At the reversal point, the majority of traders involved in BHP held the same opinion. This opinion roughly went along these lines: good shares always make new highs, my broker says it’s going to reach $30, we are in the middle of a bull market, good shares never go down, etc., etc. Each one of these phrases is designed to confirm the prevailing opinion, and imagery such as saying a share is cheap or undervalued is very powerful. Crowds are susceptible to very simple phrases, since, as we have seen, the market is a very emotional place, and reason dissipates in the face of positive emotions. These powerful phrases also have the added weight of being elucidated by someone in a perceived position of authority: a broker. As such, many in the market take these pronouncements to be some sort of mysterious divinity that should not be questioned. The power of the expert should not be underestimated in shaping the beliefs of the investing public. These beliefs are also reinforced by the fear of missing out on future gains.

However, as we have seen, there is simply not enough money to sustain continual moves in a given direction, and momentum will falter. This faltering can be seen in the first part of the move away from the high. It is important to note that this initial move down is the reversal point. The underlying sentiment in the market is beginning to change.

Some astute traders will have seen this change in tone and will begin to sell. Prices are now in an uneasy equilibrium between bullish and bearish. This unease is beginning to filter into the mood of market participants, since prices are beginning to slip against positive expectations. The successful group – who have ridden BHP up – are now in danger. Despite this, they will cling to their positive expectations, even in the face of mounting evidence against them.

The Retest

This phase is the last attempt by the bulls, who had been very successful, to reassert themselves, and momentarily their beliefs are confirmed, as the stock rallies. Their fear of missing out on potential gains is somewhat assuaged. This is a classic bear trap, and it constantly catches the unwary. It is at this point that technical indicators will contradict the move up. Astute traders with a good trading method will now be getting extremely powerful sell signals. Sentiment has swung the way of the bear. The bears are about to become the successful group, and the bulls are about to feel the pain of unrealised expectations. Fear starts to raise its head among the bulls, as expectations diverge from reality. Traders have gone from expectations of a never-ending series of highs to the unpalatable truth that prices may actually decline. The interesting point to note is that this fear does not translate into action, as we will see in a later chart. Fear among market participants is initially manifested as paralysis, as they face mounting evidence that their opinion is wrong.

The Confirmation of the New Trend

Crowd sentiment changes at this point. The downward spikes in price shake more of the bulls from their positions, and they join the bears. The crowd now starts to look for justification of its opinion in the underlying fundamentals of price. Note that price comes before fundamentals. Fundamentals serve merely to reinforce existing feelings about a move.