Back on December 13 my friends who like to like to classify stocks as “leaders” were telling me to buy CMG. “Its a leader” they said. “and its right at support. You can’t go wrong. The indexes will not go up without the leaders and everything looks nice for a continued move up”. When I said I wouldn’t touch it they argued with me that the furthest down it will go is the 50ma on the daily chart and will springboard from there. I still insisted that I wouldn’t touch it and told them I would tweet out the reason why. That evening I posted the following chart to chart.ly.
The chart in the inset is The Sentiment Cycle first described by Justin Mamis in his book titled ” The Nature Of Risk”, 1991. A more detailed description of The Sentiment Cycle is provided at the end of this article but for now I just want to mention that it is one of the few pictures I have on my wall in front of me over my trading desk all the time. As I look for pullback buys I am constantly watching the charts to see where it is in this cycle. Over the years it has amazed me how many times I have seen it played out over and over. Here is a better look.
When I looked at CMG that day I couldn’t help but think that it looked like it had just passed the “Enthusiasm” stage and was ready for the drop that it might not recover from for a long time. This is what the CMG chart looks like today.
See how the cycle is playing out? Nothing is a given, but because experience has taught me that this cycle is seen more times than not I will always give it the benefit of the doubt so I am not the bagholder that buys into the “leader” just when it decides it isn’t going to lead any more.
Just for fun, lets look at some that may be following the cycle so we can track them over time.
OK, you have the picture now. Print out a copy of The Sentiment Cycle and put it on the wall over your trading desk. I can assure you that it will keep you out of trouble more times than you can imagine during your trading career.
Here is a more detailed description of The Sentiment Cycle for those of you who would like to understand the psychology behind it. ( From a presentation By FuturesTechs.co.uk here )
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.
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.
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.
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.