From Extreme Fear to Excessive Optimism (At the Same Price Level)

In this post I wanted to take a little walk back in time to try to get a grasp on the psychology of the market, and retain a longer term time perspective. I think many mistakes are made out of lack of a long term time perspective both in general and in this case in market outlook.

Basically I want to take everyone through the market action and psychology since the Oct 2008 crash lows. But to get started, the first chart shows a more recent view of the market which looks like a short to intermediate term high is in place.

Click on Chart to Enlarge

The chart above shows 2 successive bearish engulfing patterns after the recent brief break above the tight range over the last month. I feel good about the current short-term trade, and will consider rolling it into the intermediate time frame section or posting a separate trade in that area soon.

The question arises any time a high is in place, of what degree is the high or how long the correction will be. We just have to take it one step at a time, but the first thing to look for is whether the last leg up is retraced in less time than it took to form. Then is the correction larger and faster than any other correction against the entire rally? If so then a large correction of the March-December advance is likely underway. Then if the market would happen to retrace the entire move up since July in less time than it took to form, we would be pretty certain that another major bear phase is underway.

Click on Chart to Enlarge

Looking back to Oct. 2008, we witnessed a crash of historic proportions. On Sept 29 2008, the market fell 7% to a new 52 week low. Looking at past historical comparisons, the norm was for a modest bounce then a modest undercut of the crash low over the next 1-2 weeks before stabilizing or rebounding further. Out of the handful of times that had happened before, most times the market was trading higher a week later and some were major lows.

What happened was that the market managed a miniscule bounce before plunging another 25% over the next week or so. That was worse than any of the historical comparisons with the closest being a major decline in 1931 during the Great Depression.

Since that point my view has been that the failure of the market to rebound from such a crash is a sign of long term weakness. The chart above has several notes regarding the market action since that crash. The initial reaction from the Oct 10 2008 low was the most explosive rally of the bear market. New phases of market psychology typically begin with very explosive and often relatively brief thrusts counter to the prior trend.

While the Oct 2008 lows did not hold as bear market lows, I think it is reasonable to view the shift and recovery of market psychology as beginning at that point. If that is the case, then I believe the market is at a point of extreme risk at the current level. Since that time I see 7 major price legs formed (though not confirmed the current one is over) which is almost always the maximum number of legs/waves of a correction before the prior trend resumes.

Pattern analysis is inherently subjective, so I don't put too much emphasis on it. Without specific rules, I don't think pattern analysis has much value. But when coupled with historically consistent logical concepts regarding price velocity and trend direction, I believe it can be quite useful.

Click on Chart to Enlarge

This final chart contains some pattern labeling and more importantly some blue boxes showing a 1 to 0.618 time ratio. This past week marked a possible important time point for a major pattern completion when staying with the idea that Oct 2008 marked the end of the prior downtrend.

The simplest and most objective take away from this chart are the green and red dashed lines. The green line shows the market retracing the June-July decline and breaking of a minor trendline in much less time than the June-July decline took to form (about half the time). This is the type of price action that you see at the start of new patterns or psychological phases. Also back in Nov 2008 the market retraced a major rally from late Oct to early Nov in equal time and broke the base trend line (red dashed line) in that time frame as well.

Since July 2009, it has been the norm for the market to retrace all downward corrections in less time than the correction took to form. When we see this change, we are likely in the midst of another sizeable correction. So in this light, I am viewing the Nov low as the defining point for any coming correction. If the market moves back below there in less time than it has taken to rally to the recent highs, then we are back in bear market mode for a while.

Also as an interesting point of psychology, the crash last fall really began with the Lehman Bros ordeal in mid September. Prices made a sharp rebound, but when that level was breached, the bottom fell out of the market into Oct. As of this past week, things have come full circle as price has moved back to the Lehman Bros mini crash low. At that point in Sept 2008 there were many signs of excessive pessimism and fear. Now, we are back at the same price levels with a complete flip flop in perspective. Optimism and complacency abound in the real money measures of market sentiment as well as surveys, etc.

If the market is able to exceed that Lehman crash level, then the charts and underlying psychology are such that the next major point of inflection is not till 1265 on the S&P. I have a very hard time seeing that happen before a significant correction takes place.