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Investor Sentiment in Bull/Bear markets

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As I write this article, Indian equity markets are trading at new 52-week highs and very close to their all time high levels. After seeing such strong momentum the one question which still lingers in the minds of many investors is whether we can trust the strength of the market or blindfold ourselves to the actual truth.

More precisely, ARE we in a BULL market or is it just a strong Rally from the deep lows?

post imageI believe that the key to understanding the markets and also to trade successfully is to understand the psychology of an investor at every stage of markets. Why do resistance and supports occur on charts and why does price correct from these levels. It’s because there is a significant amount of investor sentiment seen at such levels. The more the time taken for a chart formation and the more the number of shares traded in a range, the more powerful is the breakout/breakdown, because of the high number of sentiment’s involved.

The two most widely used terminologies for depicting the investor sentiment are ‘optimism’ and ‘pessimism’.

Let us discuss the case of a bull market. In bull markets there is an aura of euphoria and exuberance amongst people. The general outlook of an economy is that of prosperity, probable decoupling of the economy from other world markets, to put it crisply, there is ‘optimism’ everywhere. For example, according to the socioeconomic theory, a very interesting theory is that, in bull markets we see that animation movies perform very well. This is mainly due to a cheerful sentiment among the people.

There is an urge to outperform our counterparts in bull markets. We don’t want to miss out on any new ideas and want to implement every new strategy to make big returns. This gives rise to a sense of speculation in the minds of a so called ‘investor’.

Speculation is an activity seen more when there is subjectivity and good amount of difficulty in determining the true value of a stock. Speculation in stocks pushes the prices to unfathomable levels.

During a bubble however the propensity to speculate is high, many big sized players in the market argue for higher valuations for a young, currently unprofitable but good potential for growth. By contrast, the value of a firm with long earning history and tangible assets is much less subjective, and thus the stock is likely to be less sensitive to sentiment. That is probably the reason why we see a string of previously unknown companies making headlines, we see a good number of IPO’s in the markets getting launched and many of them even with a satisfactory business model making it big. I believe that is where the crux of the bubble scenario is, that the midcap and the small cap stocks will always give higher returns as compared to any other large cap stocks. Such mid to small sized company stocks give good returns, because of high amount of sentiment involved in them.

Now let us discuss the case of a bear market, there is fear and panic around. The general belief is that the worst is not yet over, and there is still more to come. Investors are made to believe that the fundamentals of a company cannot improve any further. In the socioeconomic theory, by a similar logic to that of bull markets, more horror movies would get successful, because of the fear existing in the minds of the people.

Corrections are generally sharp because there is FEAR which is the predominant sentiment involved. As I quote from one of the famous dialogue writers “Madness is like gravity. All it needs is a little push. Nobody panics when things go according to a plan, even if the plan is horrifying.”

I am sure very few people are aware of the HEM-line indicator. The theory states that the stock market rises and falls with women’s hemlines. This is another example of the prevalent psychology of the investing public.

I think the bull and bear phases of any markets are formed based on the sentiment of the investor.

The key to making money in stocks is not to get scared out of them.

–          Peter Lynch


www.lkpsec.com

 

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Written by Kunal Bothra

October 18, 2010 at 5:10 am