I have just returned from a very successful MoneyWeek Trader workshop – and I hope everyone there had as much fun as I did. I was asked some very pertinent questions, and we discovered some revealing patterns on the live charts. Altogether, it was a great day!
While I was away, we saw an unrelenting rise in stock markets. This is a stark illustration of a theme that is at the heart of how markets work – and how they turn.
Here is the FTSE daily chart for an eight-month span:
The area I want to focus on is the final run to the 22 May top – a high which still stands.
This area stands out because of the sheer slope of the rise. This slope far exceeds anything that preceded it.
Now, this section lasted 24 days and in that period, there were only four down (red) days. And the rise was over 600 points (a rise of almost 10% in the index!)
That is a massive move without any real set-backs. There were no decent-sized dips along this path. That is quite unusual.
When to swim against the tide
In terms of market psychology, what was going on?
Evidently, with the buyers in full control and the bears retreating, an agreement had been reached that prices were going higher.
And as the market worked higher, more and more people were converted to the bullish camp because they sensed an even bigger leap upwards. The economic data – and the Fed quantitative easing (QE) rumours – were all stoking the bullish flames.
So, with the vast majority of traders bullish as we headed into the fateful 22 May date, could the rally be sustained? After all, the ‘fundamentals’ were still favourable. So was there anything that could stop the rally?
You also had to wonder if it would be crazy to be bearish and swim against this considerable tide.
At times like these, traders need to be more bearish. Traders should have recognised that as the market rose, the bulls would eventually run out of ammo because they had spent most of it in the run-up.
So when the bulls ran out of buying power, the market turned – and the bears took control.
As the market fell after the 22 May high, the late-to-the-party bulls were therefore suffering losses and had to sell. This heavy selling pressure – together with that of the newly-emboldened bears – produced a decline that was about as fast as the rally.
You can see the excess of red bars over the green (up days) on the decline.
But you should also note that the fundamentals had not changed. So why had the rally turned into a rout?
The simple answer is that sentiment had changed – and that is reflected in the sentiment readings.
With the market in decline, many bulls were converting to bears. In other words, trader sentiment was getting more bearish on the dip.
Factoring in trader sentiment
To recap: on the rally, bullish sentiment was rising. On the decline, bullish sentiment was falling.
The market follows trader sentiment.
So I have to ask myself: how can I measure this trader sentiment? After all, if I can measure it and monitor its progress to a high bullish reading, I should be able to forecast where the market is likely to top out.
I could then place high-confidence short trades to take advantage of the forthcoming declines – which is a trader’s dream.
As it happens, there are several measures that give me clues, and I follow them avidly.
Sadly, there is no sentiment data published on the FTSE. But I use the US data as a proxy.
Here is the most recent Daily Sentiment Index (DSI) plot against the Dow:
(Chart courtesy of elliottwave.com)
It is evident that market highs are marked by very high bullish readings, and vice versa. In fact, this is an iron-clad rule: no significant market high is marked by a low bullish reading. I have never come across a situation that breaks this rule.
Don’t get caught in the herd
Gazing at the 22 May Dow high, DSI was 92% bulls (and only 8% bears!).
And that was a major high.
Therefore, 92% of traders were totally wrong on 22 May.
This is a perfect example of the herding instinct.
My advice: when you run with the herd, make sure you escape before the DSI reading gets too high.
As a trader, I take advantage of this knowledge because an extreme bullishness always precedes a market reversal – and I use my tramline method to pinpoint low-risk entries.
OK, let’s examine the latest FTSE rally:
So far, the latest leg up has taken 13 days. And there have been only two down days. Does this remind you of the previous period?
The slope of the rally is also very steep, and the DSI on the Dow is approaching previous extremes where tops were made.
With this in mind, do you expect the market to continue its steep rally? Or do you think that the market will find a top in the near future before repeating the exercise, as occurred following the 22 May high?