Over the last 100 years that analysts and psychologists have been covering financial markets, one constant in particular has never changed, that of investor psychology.

In this regard, the use of Dow Theory is of particular relevance in that it gets inside the psychology of the market, and is based on the premise that human behaviour is largely predictable when part of a herd.

The premise is that all information about an asset is reflected in the price, including that of emotions, sentiment as well as the relevant information currently known about the asset in question.

Given that the price is then driven by the usual fallibilities of human behaviour, including the mindset that “this time it will be different”, this behaviour tends to be repeated in history.

In a rising market the euphoria and emotions of traders and investors can drive valuations to particularly heady levels, with the belief that these levels can be sustained. This can be the point of maximum danger and complacency.

The easiest way to observe this is by way of the graph below:

Source optioalpha.com - 2011

By studying this graph, we can see that the majority of the herd tend to arrive near the end of a trend and that as such the last bullish push higher takes shape to make them believe that the market will continue to go higher.

This year’s move higher in the DAX to record highs could be a classic example of this euphoria phase with a last gasp push higher to record highs .

The big question now arises as to whether the down move seen in August is the “Denial” phase seen in the chart above as the equity market starts to roll over.

In other words, the decline this summer was perhaps not a medium-term decline in an uptrend, but the beginning of the end of the long-term bullish movement.

If we assume that market trends are impacted by emotional cycles, it is then necessary to analyse how often these cycles occur. The answer appears to be about 7 years.

Over the last 40 years we can see that every seven years or so we get a macroeconomic or political event that generates or precipitates a loss of confidence and in the process results in a market plunge.

These declines in the equity market usually prompt a washout in investor sentiment pushing people out of the market at a time when fear is at its greatest.

This is usually the same time when institutional investors start buying in again, following the mantra of Baron Rothschild, of the famous banking dynasty, who famously said that the best time to buy is “when there’s blood on the streets”.

Calendar of previous stock market crises, when will be the next?

The following facts would support the thesis of a potential future crisis:

• China's slowdown, the global economic engine
• Quarterly profits fell in the US for the first time in 7 years
• Emerging countries crisis and currency war
• higher valuation of shares in the US and Europe

Conclusion

Awareness of the macroeconomic and historical environment which we are now in could potentially be very important for the preservation of trader’s capital and trading success.

Over the last 20 years the SP500 has seen three strong bull markets, one in 1995, which ended up with the slide from the 1998 peaks, bottoming out in 2002, before a new 5 year bull market until the 2007 peaks.

Finally, we often say that a chart is worth a thousand words. What do you think of this one?

Source: CMC Markets, September 2015

For further comment from Nicolas Chéron, please call 0033 153831425 or 0033 763948105

Email: n.cheron@cmcmarkets.com

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