A
fascinating study is the psychology that accompanies a prolonged sideways
market trend. It also holds insights
into what the future likely holds for stock prices.
When
equities get stuck in a sideways trend for several months, investor psychology
goes through four basic stages of change: 1.) initially they feel expectant
that stock prices will quickly breakout of the newly formed range; 2.) when
this fails to materialize sentiment turns sour as stocks drop to the lower
boundary of the range; 3.) as stocks continue bouncing from the top to the
bottom of the range investors begin to lose interest and eventually quit
participating altogether with many selling their stock holdings. This is what forms the basis of a bullish
accumulation pattern since “smart money” professional investors eagerly snap up
the disgorged supply from disgruntled retail investors. 4.) Finally, as the range is nearing its
final resolution, small investors who may, or may not, be invested are
thoroughly frustrated at the lack of directional movement.
The
frustration that has built up during the period of the lateral trend is
released in various ways. Not
uncommonly, trading range breakouts are preceded or accompanied by various
expressions of mass frustration, including protests, civil unrest or
conspicuous acts of violence. If the
trading range continues long enough the subsequent release of pent-up tensions
can even result in the initiation of military conflict. Witness the collective angst of Americans of
all walks of life during the 1970s, a decade which was entirely encompassed by
a lateral trading range in the stock market.
In
my 20 years in the financial industry I’ve concluded that nothing exerts as
profound an impact on mass psychology (to say nothing of investor psychology)
than a prolonged sideways trend in equity prices. Why this should be is open for debate, but I
have what I believe are valid insights.
In highly developed capitalist nations such as the U.S. the stock market
is the single biggest barometer for measuring the collective expectations for
the business and economic outlook among all participants. The majority component of the U.S. economy is
finance, directly or indirectly. Therefore
everything concerning the material prosperity of the nation ultimately depends
on the stock market.
It
can also be observed that humans by nature are so conditioned to the concept of
progress that anything which seems to undermine the longing for growth is
viewed with contempt. A sideways trend
in stock prices over a long period of months or years is rightfully seen as the
antithesis of progress, hence the deep seated psychological frustration which
underlies a trading range environment.
The
recent breakout from the trading range in the U.S. stock market has witnessed a
corresponding increase in militant threats in several regions of the
globe. From last week’s failed
cease-fire between Ukraine and Russia, to the fighting between Egypt and ISIS,
to President Obama’s request for new war powers, the confluence in militarism
has coincided with last week’s trading range breakout. The timing is no coincidence; indeed, it can
be viewed as a natural reaction to a long and grueling period of no progress in
the financial market.
Another
aspect of trading range psychology is what I call “trading range
trepidation.” I coined this term back in
2005 and have long observed its repeated influence of investors’ collective
psyche. Trading range trepidation is a
mental state which investors collectively feel when the major indices have
spent many weeks or months in the lower portion of a range, then rally up to
test the trading range ceiling. As the
upper range is reached, investors become apprehensive. They’ve long been conditioned to seeing
stocks rally to the former price highs, only to fall back and fail to pierce
through the upper trading range boundary.
Skepticism has been thoroughly established at this point and scarcely
anyone believes that the market will break free from the confines of its upper
limit.
When
prices reach the upper band of the range, participation even among active
traders tends to wane except among short sellers. Few traders are interested in buying along a
trading range ceiling. Only when a
decisive breakout is made above the ceiling do investors begin to show any
interest.
“Breakout
shock” is a term that describes the psychological state experienced by
investors once the major indices finally push out from a long established
trading range. Investors have become so
numbed to the lack of action in the market that they’re simply unable to feel
optimistic about a breakout from a trading range. It usually takes several weeks after the
breakout before enthusiasm returns for equities.
In
the final analysis, the trading range environment of the last several months
has resulted in a depressed mood among small retail traders. While the more well-heeled individual
investors which comprise much of the weekly AAII investor sentiment poll are
more sanguine on the market outlook, the types of traders who collectively form
what is known as the “trading public” are more sullen.
The
following graph shows the Ameritrade Investor Movement Index, which tracks the
amount of money retail traders are actually putting into the stock market. As the graph illustrates, interest in the
market among Ameritrade’s clients has dwindled in recent months even as the SPX
was making new highs.
As
the current year progresses, I expect to see a gradual increase in
participation among retail investors. The
Year Five Phenomenon should provide a favorable tail-wind for equities and when
small investors become convinced that stocks are emerging from the sideways
trend, they’ll almost certainly be lured by the temptation to put more of their
money to work where it gets the best treatment.
And for the last few years that has been the U.S. stock market.
