Anatomy of a trend change

Technical Analysis plays off of behavioral patterns that investors experience during market movements. I’m a specialist in contrarian /sentiment investing, as you may know. If you haven’t read my book Smart Money, Dumb Money, grab a copy to learn more about behavioral finance. Meanwhile, lets look at the markets from the perspective of investor psychology. Today, I had a bit of fun putting together a description on the mental game that goes on in an investors brain during bull and bear trends. I applied those thoughts to todays markets. Hope you enjoy the show!

Buy the dip

Bull markets – when they are in full force as they have been since the bear market of 2022 ended this spring, tend to follow an investor mentality that works like this:

As a market trends higher, participants feel – if they are not fully invested – they are missing out. FOMO begins to set in (Fear Of Missing Out). Nothing wrong with investing into an uptrend. You are best to get into a trending market with your cash. Even better, buy the dips! In a bullish trend, each successful buy of the dip is successful. The market moves higher right after you buy.

Here’s the important part of investor psychology during a bullish trend that we need to understand: The success of buying the dip gives investors more and more confidence with each victory. Those who have cash will commit more capital in the successive dips that make a bullish trend. Higher highs, higher lows. You know the scoop.

Investor mentality becomes “buy the dip”, because that strategy has worked so well for so long.  It becomes an “absolute” that you should buy the dips because the market is going up.  Success breeds success.

Sell the rallies

After a bullish trend, we get a correction. The dips don’t recover into a higher high. Investors are dismayed that these dips aren’t like the previous dips that they had been trained to buy. At first, investors cannot recognize the turn. They’ve been trained to buy the dips. But then things change. It works something like this:

As a market trend reverses from bullish to bearish, you start to see investors buy the dip, as they had been, only to watch the proceeding rally fail, and an ensuing lower low put in shortly after. After a series of “failed counter trend rallies”, investors begin to lose faith. The new pattern of failed counter-trend rallies becomes  a meat grinder for the bulls. This happens at both the short termed pro trader level, and the mid termed retail investor level. Lets look at both.

Short termed Trader mentality: Since late July we have had 30+ days of short termed failed counter-trend rallies. Yesterday (Thursday August 24th) was a great example of this intra day reversal.  Picture this….Short termed traders such as day traders and option players have been repeatedly stopped out. Traders who are long had a cherished idea of rally-continuation. And they didn’t de-risk any of their positions in the early part of the current pullback. So now they are going home and out of simple exhaustion they will fall asleep a their normal hour. But around 1 am or so, they will wake up in a sweat. They go over their positions again and again, eyes un-blinking, staring at the ceiling. All the time, thinking of their kids, their marriage, and their job. What do you think they are going to do now? Well, they aren’t going to buy! Even worse, if the guy/gal is up on the year, he’s/she’s going to want to preserve their capital and earn 5% in risk-free cash!

Mid termed investor mentality: Recently, we had a break of the prior low when the SPX hit around 4350 – see the chart above. Mid-termed retail investors have now become nervous. 

Here’s the important part of mid termed investor psychology that we need to understand: Each failure is breeding more pain for short and mid termed traders. This pain ends up empowering further bearish price action. Those who were committing capital to buy the dips, are now pulling money out on the rallies.

Instead of “buy the dip”, its now “sell the rallies”. Failure breeds failure.

How I recognize potential trend changes

If you haven’t taken my online TA & trading course yet, I’d encourage you to do so – click here for more info. I have had hundreds of people enroll, and have given 100% positive feedback. In the course, I go into my entire trading system used as a professional trader and Portfolio Manager at ValueTrend. I can’t go over the entire system in this short space, but I can provide a couple of key factors to watch.

First of all, the major trend did change from bearish to bullish this spring. The market broke out of its 4200 neckline resistance point. That 4200 now represents major support. We are in a macro bull market.

However…It is clear by the current action that we are in a shorter termed bearish period. People are selling the rallies, as described above. You know that I have been calling for this counter trend rally. Check my past blogs. Unless we see a crack of the 4200 support level, we must consider this a bull market pullback. Note: If 4200 fails, we are back in consolidation or bear market mode.

Lets assume that the bull is intact, and there’s enough evidence to suggest that the short & mid termed traders are in “sell the rally” mode. This suggests a move back to 4200 or close to it – and then support from there. AKA … a buying opportunity. Seasonal trends may or may not influence the timing on this potential journey back to 4200-ish, but for what its worth:

“Through the remainder of the month and into the first week of September, selling pressures tend to alleviate surrounding the Labor day holiday period, but the weakest time of the year for the market is directly ahead during the back half of September.” – Equity Clock.com

Bottom line

There’s a psychology at work here. Traders gonna be traders. Markets need a reason to find a bottom, and that reason will probably come in after another 100 points or more on the SPX. Meanwhile, sit on some cash, and enjoy the show. Pass the popcorn, please!