BASIC TECHNIQUES
by Joe Duarte, M.D.
Crowd psychology plays a role in the development of market tops and bottoms. In theory, a bottom forms when the majority of investors are extremely pessimistic, and a top occurs when the investors are uniformly bullish. Here's a review of the past performance of a collection of indicators used to measure investor sentiment.
In my January 1992 STOCKS & COMMODITIES article, I described a group of seven indicators which, when combined, produced an extremely accurate forecaster for higher prices in the Standard & Poor's 500 index. Over the following six years, the indicator proved to be highly effective in predicting higher prices when gauged a year after giving a buy signal as measured by the S&P 500, during an extraordinary period in market history when the index climbed 708 points and 233 as of February 8, 1998. The indicator combines weekly stock market survey numbers, the S&P 500, a short-term moving average, and two other market sentiment measures.
On August 1, 1997, the combination of the seven indicators -- the Super Seven market forecaster -- gave its first-ever sell signal. On October 27, the US stock market as measured by the Dow Jones Industrial Average (DJIA) dropped 554 points. On December 26, 1997, and January 7, 1998, the Super Seven gave its second and third sell signals, casting a shadow over the longest bull market of the 20th century.
MARKET SENTIMENT
Financial markets express the predominant opinion of market participants about the future prospects of their underlying assets. Market participants buy because they are optimistic, and they sell because they are pessimistic. In theory, if everyone were optimistic, then the market would basically be a house of cards, as there would be no one left to pay higher prices. Any liquidation will force much lower prices as investors move to lock in profits.
The opposite happens at significant market bottoms. At bottoms, investors are convinced that lower prices of equities are a foregone conclusion, that all of the news on the horizon will simply justify waiting for better opportunities. This high degree of pessimism sets the stage for buying opportunities as the investing public waits for a sign that the worst is behind them. Since the occurrence of Tulipomania, the classic and well-documented speculative bubble of the 1600s, there have been numerous accounts of investment booms and busts. Fortunes have been made and lost by traders who failed to identify crucial turning points in market behavior.
In Trader Vic, Victor Sperandeo wrote:
The fastest and most risk-free way to make money in the markets is to identify a change of trend in a market as early as possible...
This can be difficult, as trends often reassert themselves after a break and more than once before turning in the opposite direction. Thus, a prerequisite to spotting a trend change is to identify extremes in market sentiment, which will usually precede a definite change in trend.
FIGURE 1: BUY CONDITIONS. This table outlines the parameters of the indicators for a bullish outlook.
Joe Duarte is an occasional S&C contributor and has been featured as a CNBC market maven. He is a registered investment advisor, president of River Willow Capital Management (12240 Inwood Road, Suite 207, Dallas, TX 75244), and the publisher of The Wall Street Detective newsletter and The Wall Street Detective Online (www.wallstdet.com). He can be reached via E-mail at forestln@msn.com.
