Since the September low the Nasdaq has risen 30%. Back in April the market made a similar move within the space of two weeks after that "bottom" and then topped out a month later. Just like back then, a lot of people assume that this rally is the beginning of a new bull market, while many others think it is going to start to drop tomorrow. The big question everyone is asking is how much longer will this rally continue?
This rally has the feel of the market rally that started in April. Both began suddenly and caught most people by surprise. They sat and watched it and then decided to get back in right as it began to top out.
Most people think that stock market bottoms happen when prices get so cheap that institutions and big money start to buy and that tops happen when all of a sudden people start to sell. Things don't exactly work like that.
During extended market downturns, which we have seen a lot of over the past 18 months, sellers take control. During this time there are three main groups in the market. The smart money which sells the rallies and the optimistic and wild gamblers that think that the time to buy is when the market drops because the prices were higher last week. Lastly there is the man sitting on the sidelines and worrying as he watches his "investments" shrink in value.
The first group, the smart money, is the first to sell and get out at the beginning of a downturn. Most people don't believe it is a downturn at first and buy the dips or just watch and don't think about it. As each successive rally gets sold by the smart money and the market drops, the buy the dip gamblers start to buy. They do not cause the market to bottom. In fact as a downturn wears on the buying pressure they creates dissipates as they lose more and more money. Their main job in the market is to act as bag holders and they do this well.
The market decline ends when the selling ends. It ends when the smart money finishes selling and the sideline worriers throw in the towel and block the doors in a rush to get out. These average individual investors flip flop between thinking about selling and convincing themselves that everything will go back up. What happens to these people is that they worry each day the market drops, but find reasons to hope it goes up a little bit or every time they hear some Wall Street analyst lie and say that stocks are cheap. Finally just as the market is bottoming they decide that they can't take the worries anymore and sell in a panic.
Stock market bottoms often end in a final wave of panic selling not because all of a sudden buyers come in to make it go up, but because downturns can only end when sellers lose their power over the market. That only happens once they finish selling. All potential panic sellers and worry warts have to disappear. The VIX rises and put buying dominates options activity, because it is the fearful and panic stricken who are most active in the market at the bottom.
You can flip this whole process around to understand how extended market rallies - like the one we are having now - end. They do not end when sellers all of a sudden appear in the market, but when the buying pressure that fuels the market exhausts itself. Only then do sellers get the upper hand. There is a saying that bull markets rise over a wall of worry. What that means is that as the market rises people worry that it will pull back so they just sit and watch. They think about buying and want to buy, but periodic corrections happen that convince them that they need to stay out.
They are most worried at the beginning of a market rally. But as they watch each successive rally happen they get more confident about the market. More and more people get in as the market rallies towards its top. Finally right at the top the final potential buyers who were sitting on the sidelines decide to jump in. Now there is no one left to fuel the buying pressure and the sellers have no problem taking over. They don't have to do anything, but simply be there.
Because few are worried. optimism reigns supreme at market tops. The VIX drops to the low 20's and call buying dominates the options market. Markets do indeed rise over a wall of worry. But once it crosses over that wall they fall; and in bubble markets investors find that there is nothing on the other side.
Right now the market is rising, but the VIX is trading in the high 30's and there is still a lot of put activity in the options market. That means there is still a lot of fear in the market and tells us that this rally will continue. As long as there is no more terrorist activity on the magnitude of the World Trade Center bombing, I believe that the September low will hold through the rest of the year. I do think these lows will eventually be tested, but everyone will get super optimistic again before that happens. Good trading opportunities will appear for breakouts, but when this rally approaches its end we'll be looking to short. I'll talk more about what I think will happen after this rally ends tomorrow. |
