Commentary From InVivoAnalytics

At my request, Teresa Lo of InVivoAnalytics prepared the following market commentary for my readers. With thanks to her, I present:

Where We Are In The Cycle

by Teresa Lo

In early January, a number of technical analysts thought they had spied a head and shoulders bottom forming on the daily chart of the S&P; 500 Index:

At the time, I wrote, “I’ve seen variants of this chart all over,” and provided an example of a more textbook formation. As I pondered the reasons why such an unorthodox pattern would come to be interpreted by so many as a head and shoulders bottom, it occurred to me that the art of forecasting also requires the practioner to be an impartial witness to price action, someone with a solid understanding of market psychology.

In my opinion, the best book ever written on the subject is the one by Justin Mamis. In The Nature of Risk, he provided a blueprint for the timeless investor sentiment cycle that explains why investors tend to buy high and sell low. As Mark Twain observed long ago, the past does not repeat itself, but it rhymes. Having been involved in the markets for over twenty years, I can certainly say that I’ve seen the cycle many times, and experience has made it second nature to view price action in the appropriate context. On February 5, I reminded readers of Mamis’s description of the making of a major head and shoulders bottom:

The consistent ingredients of a bear market that leads to an important bottom are the following:
  1. The initial breakdown and collapsing phase that because of its vehemence seems to be a sufficient decline in itself. (Point A)

  2. Because of widespread conviction that the worst is now past, some successful testing of that low is followed by bear market bounces that keep investors hopeful, and even convinced that the market is okay again. (Point B)

  3. A surrender, and fresh slide that, as they come to “know” why prices have been falling, can go on and on like Chinese water torture.

  4. The give-up phase during which the pain increases because the “known” reasons seem to be getting worse and worse, and feel as if they will be even worse tomorrow. (Point C)

  5. Signs that almost everyone who had owned has now sold begin to materialize when more bad news fails to carry prices any lower, followed by a bounce that is dismissed as “merely technical,” and thus is deceptive enough to keep the crowd too fearful to believe. Denial of positives. (Point D)

  6. Renewed belief in negatives. (Point DD)

  7. Aversion. (Point E)

  8. Positive action; met with suspicion. (Point F)

Points B and D join to form the neckline while Point F is made on the upside breakout.

This bear market has been tough on everyone; it was even difficult for me to make the call. On February 5, I wrote:

If we look at the descriptions of Point C and Point E, it would seem like we have a pretty close match. And if we draw a line to connect these two points, we would even have a triangle. Right now, it sure feels like Point E, the “give-up phase during which the pain increases because the ‘known’ reasons seem to be getting worse and worse, and feel as if they will be even worse tomorrow.”

But at the same time, there is a good possibility that we are only at Point B (and the Discouragement phase is still ahead of us) because just look at the news flow and how the market reacts — the good bank/bad bank last week, the “relax mark-to-market” thing today, the stimulus bill tomorrow — everyone is still holding onto hope. . . . Let’s put it this way: They feel like it’s Point E, but I am not so sure; it might be closer to Point B. We need to see some decisive price action to the upside. Big time.

The Nature of Risk contains a schematic diagram labeled with two Points B, and it is precisely by joining these that other analysts made the call for an unorthodox head and shoulders bottom. Listening to the market might have made it easier to correctly identify Point A as the so-called Art Hogan bottom. My impression was that market participants were still hopeful when the lower low formed in November 2008 and when it was taken out followed by the big panic gap down on March 2, 2009, the stage was set for surrender. Last week’s price action was replete with stories filled with the fear that no bottom could be found above zero:

  • March 2: AIG rescued again as top economies shrink – The latest revision of the AIG bailout includes a $30 billion equity commitment from the U.S. government that AIG can draw on as needed. Investors feared the U.S. government would have to stand by AIG no matter how much it bleeds because its collapse would ripple across borders. AIG guarantees about $300 billion of asset-backed securities and U.S. and European banks are counterparties on many of AIG’s outstanding derivative contracts.

  • March 5: Slump Humbling Blue-Chip Stocks – The banking giant Citigroup commanded a stock price of $55 just two years ago. But at one point Thursday, as markets hurtled to their lowest close in 12 years, the shares were worth less than an item at the Dollar Store.

  • March 6: See What People Are Saying About The Elusive Market Bottom

  • March 6: Picking a Market Bottom: Why the Pros Are All Wrong – Some of the smartest minds on both Wall Street and Washington have tried numerous times to identify an ultimate low for stocks and have failed — in some cases miserably. The bookend collapses of both Bear Stearns and Lehman Brothers served in the minds of some as critical points of capitulation. For others, the “bottom” was election-related. Still others tied their bottom calls to various legislative developments. So far such pronouncements have had one thing in common: They have all been wrong.

When the penultimate sentiment indicator kicked in on March 6 — big downward projections — I wrote:

One of the kisses of death on the upside are analysts projecting ever higher highs after a huge move up. Remember $250 QCOM? $250 oil? The same thing happens
near significant, tradeable bottoms and what did we see today? Big percentage downward projections. Louise Yamada was on Bloomberg, CNBC, New York Times, Barron’s, Forbes, MSN Money, etc. She was everywhere. The skinny lady belting out downside targets has to be a big sign.

At this juncture, all eyes will be on the major stock indexes to see if price can continue upward. If they can trade trade back into the November 2008 low, pay close attention to commentators and analysts featured on CNBC. We’ll know Point D has been reached if the bounce “is dismissed as ‘merely technical,’ and thus is deceptive enough to keep the crowd too fearful to believe.”

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