The Psychology Of Investing (Part 1)

Successful investing is about far more than understanding value, balance sheets and quality of management.  One also needs to be a pretty good amateur psychologist.  Virtually all market tops and bottoms occur at emotional extremes:  Bottoms coincide with widespread panic while Tops tend to be associated with some unjustified level of overconfidence or greed.

We continue our very bearish stance on virtually all of the capital markets.  We've given dozens of reasons that this so-called "recovery" is unsustainable and, with it, a major, major peak is being formed in the capital markets. 

In addition to all the reasons for concern previously discussed, another subset of technical analysis referred to as "sentiment" analysis is clear in its verdict:  SELL!

The theory behind sentiment analysis is quite simple, and so logical that Mr. Spock himself would not even raise an eyebrow.  Market peaks occur when buying power has become exhausted.  This happens because those buyers have become either complacent, overconfident or just plain greedy.  Once they've all bought in, who's left to buy?

This level of emotional extreme can be measured quantitatively, so one need not be an empath to get a good fix on things.  The most basic form of sentiment reading is the market poll.  There are several which have long track records, are consistently applied and easily accessible for historical analysis.  The two of note are Investor's Intelligence which polls newsletter writers and the American Association of Individual Investors (AAII) which polls retail investors.  Barron's reprints a number of these polls every week http://online.barrons.com/public/page/9_0210-investorsentimentreadings.html.

The AAII poll currently shows 49.7% bulls versus 26.2% bears.  These numbers are at major, major top historical readings and suggest any further upside from here can not be ruled out, but must be viewed as quite limited.  Investor's Intelligence confirms similar results.  The most recent readings are consistent with levels virtually identical to the tops reached in 2007 and 2000, with 55.4% Bulls and 21.8% Bears.

Other sentiment indicators are less precise but, nonetheless meaningful.  Just two days ago, Goldman Sachs issued its 12 month projection of 1,450 on the Standard & Poors 500 (SPX) or a gain of 25% from here.  This forecast was not directly attributed to "Dear" Abby Joseph Cohen, but suffice it to say that Ms. Cohen is a notorious perma-bull who never met a reason not to recommend stocks even at extremes of overvaluation.  She was quite bullish at the upper end of the Nasdaq bubble, issuing bullish forecast after bullish forecast.  Somehow, she kept her job.

There is the "Magazine Cover" indicator.  Mainstream publications like Business Week, Time and Newsweek are famous for having cover stories about the "Death Of Equities" or the "New Age of Investing" almost exactly at market peaks and bottoms.  These publications act as investor polls in and of themselves, merely reflecting what their readers believe.

Another excellent sentiment reading, and probably the best one of all, is the level of market volatility.  This one may be best because it's determined through actual trading.  Volatility is a statistical measure of the expected degree of variability in stock prices over various subsets of time.  It is a key component in options pricing, but very, very useful in understanding exactly where investors sentiments lie.

There are several measure of volatility, but the best one is called the VIX, which is its symbol.  At market bottoms, the VIX will have readings of above 50.  Literally translated, this means that investors have priced in a range of up or down 50% over the coming year.  At the other end, VIX can print under 10%, indicating complete complacency or lack of fear.  A 3 year chart of VIX can be accessed by clicking here:  http://bigcharts.marketwatch.com/quickchart/quickchart.asp?symb=vix&sid=0&o_symb=vix&freq=2&time=10.

You will note that VIX is currently incredibly low and confirms the very ominous readings mentioned above in the investor sentiment polls.

Think this is all there is to sentiment?  Not even close!  In Part 2 we'll discuss other very interesting indicators of how investors deploy capital and how it gives us pundits a means of understanding what's in their heads.

All in all, this is still a time to remain very, very cautious and keep levels of cash high. 

Marko's Take

Market Waterfall Fast Approaching: How To Benefit!

All signs point to an imminent, violent and downward move in the stock market.  Fortunately, as a reader of "Marko's Take", not only can you AVOID it, but you can BENEFIT from it!

First, let's go through the reasoning.  The Dow Jones Industrial Average (Dow), recently broke a very reliable chart pattern known as a "rising wedge" or "bearish wedge".  This pattern is characterized by a series of higher highs and higher lows, but the pattern of highs and lows eventually cross, forming an upward sloping triangular shape, or "wedge".

As the market moves to the apex, or point of crossing, it can only do one of two things - break up or break down.  Normally, these patterns break down and when they do, it is highly likely that a key reversal has taken hold.

Second is the sudden increase in "volatility".  Normally, a healthy and rising market, NOT in a mania, will be characterized by low volatility or a small amount of either day-to-day fluctuation or intra-day fluctuation.  A falling market will typically experience rising volatility as investor panic sets in.  In the last two weeks the market has broken a year long trend of falling volatility.  It has suddenly spiked higher. 

Low volatility is the result of good liquidity.  In other words, as there is a better balance between buyers and sellers, market movements are dampened.  When liquidity is low, volatility rises as sellers swamp buyers and larger movements are required to entice buyers to step in.

Finally, this breakdown in stocks would be consistent with the oncoming double dip of this DEPRESSION.

So, how can you benefit?

There are many interesting alternatives - especially "inverse" Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs).

So, it depends on how aggressive you want to be.  Inverse ETFs and ETNs come in a variety of flavors.  ETFs often act as inverses by a factor of 1 - meaning that if an index drops by 1% in a day the ETF will rise by 1%.  ETFs or ETNs, on the other hand, can also use leverage and MAGNIFY the effect.  For example, ETFs and ETNs exist with both double and triple leverage.  A triple inverse ETF or ETN will rise 3% for every 1% drop in the market on a daily basis.

Some ETFs that can be employed to create a short position can be found here (http://tradermike.net/2007/03/list_of_inverse_short_bear_etfs), as can an excellent selection of double inverse vehicles.

For some of the more aggressive ones they can be found here (http://www.stockrake.com/3x-triple-leveraged-etfs~2008~11.html).

Naturally, I cannot recommend anything but merely provide you with the information.  I am no longer a Registered Investment Adviser (RIA) and need to make this disclosure.  Each of these vehicles carry tax consequences and you should consult with a real RIA, as opposed to taking my word for it.

It's a crying shame that the country is on the cusp of entering perhaps its darkest period.  But that doesn't mean that you need to go down the tubes with it.

On Monday, we'll cover the new employment data released last Friday and its implications for the economy.

Marko's Take