Trader’s Narrative

Do you remember Didier Sornette? He is the visiting UCLA professor who became a bit of a celebrity within financial circles a few years back. Sornette co-authored a paper and then a book explaining Why Stock Markets Crash. He came up with a very sophisticated model which tried to not only explain the market but predict it years in advance.

Since at the time his model was bearish, Sornette quickly became the favourite interview subject of the perma-bears. He wasn’t right of course since the market went up instead of down.

Had he been right though, you can bet he would have become a sudden celebrity, sold millions of his dry academic book, been interviewed in Barron’s, launched a hedge fund, etc.

This is what he said in an interview on March 2003 just as the market was about to launch into a multi-year cyclical bull run:

…we predicted that the stock market will go up until the first to the second quarter of 2003 and will then start a long descend until around the end of the first semester of 2004.

And here is the graph illustrating this prediction:

At the beginning of 2006 the S&P 500 was at 1270 - approximately 500 points away from Sornette’s predicton.

Now, I’m not dredging this up in order to beat up on a well meaning professor of geophysics. My point is that listening to so-called ‘experts’ is financially hazardous to your financial health. And that includes anyone on TV, radio, or dare I say it? even a blog.

Be independant and seek understanding - from that money and success will follow. There are no shortcuts in trading or in life.

If you’re interested to learn more about experts and their predictions, listen to this lecture by Nassim Taleb:

Since the last time I looked at the trend of the market, the S&P 500 has put in a higher bottom at 1235. This is the first thing we need for a change in trend. The next thing we need is a higher high.

Right now, it seems the market is working on that. If it can close decisively above 1280 and put in a higher high as well, the probability of a trend change will be very high. In the mean time the market is simply coiling within a tight range.

The Nasdaq 100 index, however, is much weaker having been unable to put in a higher low. The NDX seems to be still struggling with the 1525 resistance level.

John, from Tale of the Tape, asks a very interesting question regarding the nature of sentiment during a bear market. He wonders whether high bearish sentiment is a bullish signal during both bear and bull markets.

Well, lets examine the bear market that began in early 2000 by looking at the S&P 500 index and the absolute readings of AAII bearish sentiment that accompanied it:

Now, be mindful that the dates for the survey and the weekly candles don’t match exactly. What I’ve done is to round ahead to the next candle/week. So for example, if the survey date is May 12th and there are two candles with start dates May 8th and May 15th, I put the “sentiment” dot on May 15th’s candle. Capisce? The result is that in some instances it may appear that sentiment was ‘off’ or ‘late’ in signalling a rally… where it wasn’t really.

Some observations from this first phase of the bear market:

• first heavy bearish sentiment was waay off for the S&P (much better for Nasdaq)
• ditto for the lighter one that came right after it
• sentiment didn’t get bearish again for a long time
• but when it did, it was a great signal for a rally in March 2001
• in early stages of a cyclical bear market, sentiment can be a great tell
• but only after the market has seen a significant decline and/or correction

And the next phase of the bear from 2002 onward:

Wow! The graph lights up like a Christmas tree:

bearish sentiment went haywire approaching 1000 - right at previous support
• naturally, a lot of people became bearish as the index revisited its lows
• bearish sentiment accompanied the index’s plunge!
• clusters of major bearish sentiment can actually be dangerous!
• it is much better to get a lone ‘dot’ than a crowd of them (see first graph)
• you need severe and sustained bearish sentiment for a significant bottom
• bearish sentiment can ‘wash out’ - no real bearish reading after March 13, 2003

But remember that sentiment, especially only one measure of it such as AAII, should never be used as a tell in isolation. Sentiment as a contrarian measure is useful, but it must be combined with other tools to round out a picture.