Today, I’d like to discuss the investment cycle, and where we may be within that cycle. My perspective as a Technical Analyst involves applying sentiment studies and investor psychology to market movements (this also called behavioral finance). In my way of thinking, a properly structured Investment Cycle should incorporate investor emotion in conjunction with technical trend analysis and economic factors.
This brings me to an update on my new book.
Some of you might be aware of the fact that I am writing a new book on contrarian investing. I’m down to the home stretch – with only a few hours of self-editing left. Then it goes to the “real” editor who will tear me apart and point out what an amateur writer I truly am (its always a lesson in humility). If you have ever written a book, or know anyone who has done so – you will relate when I tell you that its a FAR bigger task than most imagine. Especially when writing a technical book. Writing a blog is comparatively easy. I just spit out whatever has been on my mind or whatever general trading direction I am focusing on that week- and presto! Instant blog.
A technical book has to flow and connect a myriad of concepts to educate the reader in an easy to follow format. My books always conclude with a final chapter called “Putting it all together” (see SmartBounce and Sideways). In that final chapter, I take everything I’ve covered – which in the current books case is vastly more information than I covered in the first two books – and help the reader incorporate it all into a manageable trading plan. My goal for any of my books has always been to help retail investors understand analytical processes in an easy to understand format. The good news is that I’m in the home stretch. For anyone who read Sideways and felt it needed to go deeper down the rabbit hole of analytics- this book is for you!!!
In the opening chapter of the book, I discuss the Investment Cycle. I present two variations of understanding the cycle. One is from the investor emotion perspective – which you may have seen before. Its the classic fear and greed cycle. Here is an excerbt from that introduction (unedited!) with a chart of that behavioral cycle:
The investment Cycle
The diagram below is one that you may have seen before. It represents the investment cycle, as driven by investor crowd behavior. The cycle moves between bull markets and bear markets as investors rotate between the various stages of euphoria and despair. (Note for todays blog: On this diagram is noted a potential position as to where we may be in that cycle right now – along with some potential timing of the next phase in the cycle.)
While examining the investor behavior cycle chart above, you may wonder how an investor can quantifiably identify euphoric market conditions that lead into market peaks. Conversely, you many wonder how we might identify declining markets near the capitation stage of a market bottom. Is there a way to identify which part of the behavioral cycle the market is currently in, and profit by these peaks of emotional buying and selling behavior? Jason Geopfert of Sentimentrader.com (you will be introduced to his work later in this book) suggests that market tops and market bottoms are often identified by a number of reoccurring traits. I’d recommend you keep the following lists handy as a “check list” to regularly ascertain market conditions. The more of the following conditions present, the more likely we are at or near a market top:
Goepfert suggests that market bottoms also coincide with reoccurring traits. As with market topping conditions, the more conditions for the list below that present themselves, the more likely we are at or near a market bottom:
• Extreme pessimism
• Oversold breadth (few stocks moving up vs. moving down)
• Risky stocks crash
• Negative media coverage
• Credit slams shut
Comments based on that book excerpt
The reason I wanted to copy the above excerpt from my soon-to-be published book was to stimulate some thinking as to where we may be in the cycle. Optimism for stock markets has been very high over the past few years. This excitement built its way into a potential crescendo that might represent those final phases of a topping market. See the top chart.
If we look at Goepfert’s list in the box above, we might draw some parallels of those conditions to current markets. Are you seeing high optimism in the markets now? Can it be argued that our current access to credit is easy- perhaps too easy? Have you noticed that secondary market offerings are rising? Would you argue that the outperformance by fairly start-up stock sectors like solar and stay-inside technologies is a sign of market speculation? Would you agree that the SPX PE ratio of 40 (trailing), which is the third highest in history, is high? Would you agree that massive valuations on market leading big name tech’s like FAANGs is high?
The problem with viewing the above the cycle is that these factors are all fairly forward – looking. We need to quantify the timing of such a top (if we are near one) by using more quantitative measurements. That’s where sentiment indicators – which I discuss in the book – come in. I use a few of the more reliable sentiment studies in my Bear-o-meter.
Today’s blog, despite the undertone of warnings, wasn’t written to have you sell your portfolio and run for the hills. Markets can remain wrong longer than you can remain solvent, as Keynes once said.
Next week, I’ll present my Bear-o-meter findings for a more timely look at current market sentiment. This might give us further insight as to where we are in the diagram presented at the top of this blog. And if we should be taking action. Stay tuned!
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