Wednesday, April 22, 2009
The Mamis Bottom Formation
In his book The Nature of Risk, market thinker Justin Mamis looked at what bottoms look like and tied it to the sentiment cycle.
At bottoms, fundamental analysis fails and trader sentiment becomes more important. Humans are hard-wired to become fearful at an existential threat. Mamis sees Panic (Point A) as the ultimate manifestation of fear of impending doom, which gives way during a bear market to Discouragement (Point C).
The climb from Point C to Point D is called the Wall of Worry and is marked by a lack of fundamental backing to the rise in stock prices. All the news is bad and the global economic picture is dire, but the market rises dramatically regardless. Sound familiar? Nouriel Roubini recognizes this phenomenon has occurred and seems surprised that the market has rallied. This shows how clueless an economist in regards to the sentiment involved in trading.
Bear market rallies occur as day follows night. From 1929 to 1933, the last deflationary downturn, we had many double digit market rallies as the market dropped 84% of its value in 40 months.
In every bear market the bad news wears investors out and there is new belief in negatives. I think is coming soon.
In the current SPY, we can see similar patterns of Panic, Discouragement and now the Wall of Worry. Eventually there will be a renewed belief in negatives and my guess is that will come soon as the bank stress tests come out and the market rally tires. Aversion phase (Point E) will need to come and that will make a higher low than the March 9th mark.
After that only good news will instill the necessary belief in the market to move stock prices up. This is only one scenario, but it may be time to take some profit off the table and even look at some short opportunities. Also, we can look at sectors that perform in various stages of the recovery.