Sentiment: Putting trading into context

By Jeff Greenblatt

Bull markets climb a wall of worry, but bears slide a slippery slope of hope. Every trader has heard these and other trading adages, but is there any truth behind them and, more important, how do we put them into practice to make money?

Typically, these sayings are rooted in market sentiment and mass trader psychology. No, the market doesn’t ring a bell at the top, but there are clues. You can see them if you are open to the message being delivered. The problem is that message is nuanced and it changes with market cycles. You have to be aware of that cycle and have a finger on the pulse of the market’s sentiment, and then the technical framework becomes much clearer.

Most traders are familiar with using news headlines as contrary indicators. Jeff Bezos of Amazon was named Time magazine’s “Man of the Year” on Dec. 27, 1999, during a raging tech mania. The bubble burst a little more than two months later. History offers us a few famous examples such as this one, but that doesn’t help a trader who must look for these opportunities on a regular basis week-in and week-out.

To find these clues, you must have a keen eye and respect the message from all angles. To demonstrate, we’ll walk through recent history, starting with the housing bubble.

Seeing is not believing

In 2007, the Russell 2000 peaked in July while the rest of the market peaked in October. Around that time, real estate agents in Phoenix started noticing their deals weren’t closing so easily anymore. Suddenly, it was harder to put deals into escrow and the ones that went in weren’t making it across the finish line. By November the media picked up on the news and started discussing the slowdown, suggesting the economy would be coming in for a “soft landing” (see “Index sentiment gauge”). The Fed acknowledged a sub-prime problem but said the situation could be contained.


Why would the media predict a soft landing? The market was up for five years and with the easy money policies of the Fed, housing prices went through the roof. Prosperity seemingly returned; it didn’t matter if it was manufactured with smoke and mirrors. People were making money again and it’s difficult for individuals and the mass crowd collectively to envision conditions radically different over the next 12 months from the prior 12 months. Anyone who predicted a serious slowdown in the economy had his sanity questioned. The takeaway is this: In early stages of any new bear phase, look for headlines of denial or complacency regarding economic problems. It also is wise to be suspicious of those touting a paradigm shift. There were many voices warning of the impending bust cycle in housing and they, like equity bears in the late 1990s, were dismissed. When their arguments proved to be sound, those not prepared for the party to end pushed the “new paradigm” argument in both cycles.

By the time 2008 rolled around, the economy wasn’t getting any better and market participants started waking up to the reality that no soft landing was in the cards. In fact, news started leaking out there were hundreds of thousands of resets on the books for late 2008, meaning many interest-only loans taken out over the past few years were close to expiration and subject to refinancing at higher rates.

By July 2008, Federal Reserve Chairman Ben Bernanke went to the Senate Banking Committee and, for the first time, the politicians held his feet to the fire because there was no soft landing nor was the housing crisis contained. This is what Elliott Wave analysts commonly refer to as the point of recognition. In terms of market sentiment, this is when psychology finally flips, the crowd realizes there is a problem and complacency turns into concern. The bottom line here is the bear phase had reached its analytical midpoint.

The swelling concern developed into a crisis, and by September/October the market and economy had passed the point of no return.

Anatomy of a turnaround

It’s not hard to determine the sentiment of a market like the one emerging in October 2008: Fear. Fear grips everyone, and depending on the degree of the crisis, it can feel like the end of the world. In 2008, it felt like the financial system was going to fail. Not every bear market ends that badly; this was a generational event.

Fear runs rampant in bear markets, but the bull can’t return until the bearish sentiment extinguishes itself. This is why at the bottom the times seem darkest — the market often as though it’s going down forever, never to turn higher again. The bottom for us was when the late Mark Haines called the bottom on March 10, 2009. It is commonly referred to by fans as the Haines Bottom.

The aftermath of a bear market is met by fear and disbelief. The bear has done its job of driving participants out of the market. Market participants and followers alike are scarred by the experience, and it colors their perception of future moves as well as the fortunes of the economy. In late 2009 and 2010 when money managers, politicians and traders were interviewed on television, the question they were asked universally was, “Do you think there will be a double-dip recession?”

Compare and contrast this to the sentiment just after the top in 2007 when people were expecting a soft landing. As the market pushed higher off the bottom, the concern, even as prices climbed, was whether the economy would slip into recession again. This is how a market climbs a wall of worry and often, even on bad news, the market will climb.

Then, an interesting twist materialized. By February 2011, when the sociopolitical movement known as the Arab Spring developed, the markets started topping out. The economy slowed down, partially as a result of the Japanese earthquake, tsunami and nuclear meltdown. The media once again started talking about a slowing economy but stepped away from double-dip recession references.

Echoing sentiment eerily similar to late 2007, the “soft landing” became a “soft patch.” It went so far that Bob Pisani of CNBC attended a charity event of hedge fund leaders on May 27, 2011, where the prevailing opinion of the traders in the room was a “see-over trade.”

In his “Trader Talk” blog the next day, Pisani reported traders acknowledged the economy had slowed down but anticipated growth again in the second half of the year that allowed market participants to “see over” or beyond the bad numbers that were materializing at the time. They also believed the Fed would keep the dollar weak. In fact, the dollar had bottomed the first week of that May, starting a long-term uptrend. Pisani’s sources also believed the politicians in Washington would not allow the economy to falter heading into an election year. This is the kind of complacency headline near a market top that sentiment traders seek.

Breaking expectations

The second half of 2011 didn’t follow the consensus. Not only did the White House and Congress play Russian roulette with the debt ceiling, but European equity bears lost billions predicting the Greek crisis would be the next Lehman moment.

There are many lessons to be learned. A wall of worry transforms into complacency; that’s one way sentiment clues us into a peaking market. But the sooner it morphs into irrational fear, it’s an indicator the bear phase can be close to an end. The scars of 2008 influenced the correction of 2011. In 2011, bears were anticipating Greece would bring down the market; it never happened.

The market has few, if any, universal truths, but this comes close: A panic and ensuing crash happen because of unanticipated events. By 2011, European banking and political officials were prepared for the crisis; therefore, it never turned into a panic or crash.

Another element to this market was the state of energy costs. It is common for concerns about supply to drive up oil prices. However, this, too, must be taken in the context of sentiment. Oil prices skyrocketed in 2005 when Katrina menaced the Gulf of Mexico. The actual fear that oil rigs would be destroyed was much worse than what actually happened. This might suggest to some that oil prices should have gone through the roof during the BP disaster in 2010, when millions of barrels seeped into the Gulf, complete with heart-breaking photographs of destroyed beaches.

The difference this time was context. Katrina materialized during a bull phase in equities where traders were fixated on supply concerns in a good economy. During the BP crisis, markets had peaked in April 2010 and at the sight of wildlife covered with oil, the crowd considered alternative choices of energy. Demand destruction concerns turned to panic, and the oil market crashed. Because the equity market spends more time in a bull phase as opposed to a bear phase, traders are more likely to fixate on supply concerns as opposed to demand destruction. This is why crude oil sentiment often is a reflection of stock market performance.

Putting sentiment to work

Interpreting headlines and media sentiment isn’t hard, but it does take practice, patience and detailed observation of the daily trend. This is not, however, trading by just wit and gut feel. Practical tools can play a role, and the Chicago Board Options Exchange Volatility Index (VIX) is an excellent one for gauging sentiment (see “Reading the VIX”).


Bear phases generally end with readings of about 35-50 and bull phases around 9-14. If the market is near an old high and the VIX is around 15, obviously it can’t sustain it for long because there is only so far the index can rise. On the other hand, if a market is near an old high and the VIX is around 25, it means a significant slice of the market is discounting the move, which can propel it much higher.

Whether reading the headlines or interpreting the VIX, using these tools is similar to watching the fuel gauge in your car. Fear reigns when the tank is on empty and can go no lower, while greed is highest when the tank is full and can hold no more. The point is that, while technical signals matter, context is everything. Before you can experience long-term trading success, you need a reliable way to identify that context — whether by discretionary analysis of broad sentiment or an objective reading of measures such as the VIX.

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