Bulls come roaring back

S&P500 daily @ 3:21 EDT

The obvious short over the last couple days is putting the hurt on a lot of premature bears.  The best trade is often the hardest trade.  Yesterday the hardest trade was buying the market.  And that turned out to be the right trade.

MARKET BEHAVIOR

The indexes staged a relief rally after five consecutive down-days, including the largest single decline in three months.  All of Bernanke’s QE-finity gains were given back as we fell to the 1430 trading range from early September.

Yesterday’s price action was a healthy pause to let investors regroup and make intelligent, rational, and informed portfolio decisions, as opposed to Monday’s crashing market that took out countless autopilot stop-losses on the way down.

No doubt a lot of today’s strength is aggressive shorts getting blown out of the water, yet again.  The time when the market sells off and the shorts are afraid to touch it will signal the real deal.  Each bear-trap moves us one step closer to that day.

MARKET SENTIMENT

We need to get in the head of the market if we want to figure out where we are headed.  Everyone who bought the Bernanke bounce was either chased out of the market or is/was underwater.  The rally was fairly obvious by that point and anyone jumping on the bandwagon was late to the party.  QE3 was the good news everyone was hoping for and after it was announced it finally felt safe to be into the markets, but as we witnessed, it was actually the most dangerous time to buy in the last three months.

It is basic human psychology combined with supply and demand dynamics that drive this market paradox.  As humans, evolution conditioned us to take emotional cues from the people around us.  If other people are freaking out, then it probably means a tiger entered the camp and even if we don’t see it with our own eyes, our survival depends on following the crowd to safety.  Same goes for complacency.  If no one else sees anything dangerous, then it is okay for us to relax too.

While this herding mentality works great in the wild, it will get your head cut off in the financial markets.  Supply and demand dynamics make it such that these rules are flipped upside down.  We can safely ignore what everyone is panicked about, but we have to fear what no one else sees.

Financial markets move based on new buying or new selling.  When the crowd thinks one-way or the other, they as the aggregate have already placed their trades and are simply waiting for other traders to come in and continue moving prices their direction.  But by the time the crowd is nearly unanimous in their views and everyone feels the most safe, all the buying has already occurred and there is no new buyers left to continue the move.  So just when you feel most comfortable is when the market is about to reverse on you.  And of course the opposite applies, when the market feels most risky is when it is often the safest to buy.

So how do we use this information?  Looking in the rearview mirror it is obvious that the safety of QE-finity was a mirage.  But we can’t trade last week, so we need to focus on what will happen tomorrow.  These five days spooked the market pretty good and brought the fight back to demoralized bears.  Riots in Greece and Spain are making everyone nervous.  The market doesn’t feel safe anymore.   And as it turns out, the best time to buy stocks was over the last two days when it felt like everything was falling apart.

An easy way to gauge market sentiment evaluating how you feel?  Does the market feel safe?  Does it feel scary?  Are you excited to buy the dip, or fearful of more downside?  If you’re relatively normal, your feelings will mirror the majority of the market.

Looking forward, the dips that scare everyone and invigorate the bears can safely be bought.  The dips that bears are afraid to short and everyone else assumes are just another great buying opportunity will turn out to be the real sell off.  After this week’s vicious bear-trap, a lot bears are likely to go into hibernation and that means we need to be far more careful of the next selloff.

TRADING OPPORTUNITIES

Looks like aggressive bears who shorted the market are getting squeezed out today.  This bounce certainly stopped the downside momentum and put many bears on the defensive.  There will be a bigger corrective wave in our future, but it usually takes a few failed attempts before one finally sticks.  More psychology is involved in why this happens, but we’ll save this for another day.  If you can’t wait, check out my March 13th post on the Psychology of a Top.

We’ll probably top 1475 in coming weeks as calm and complacency return to the markets.  You can stay long for the time being, but the more confident you are in your positions, the more seriously you need to think about selling.

Stay safe