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The markets and pschology

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I find it very interesting how quickly the market mood can change. The major equity indices all went up over 20% off the October low in just seven weeks as everyone began to call the beginning of the new bull market. Now after two weeks and a 5-7% correction, the market mood has become dramatically less festive. This is a great study of psychology because frankly not much has changed in the economic, geo-political or valuation backdrop. The news isn't so dramatically different, but the market's reaction is.

Three weeks ago when the market was surging (and peaking), the news was perceived as positive in semiconductor land as Intel (INTC) was guiding higher and National Semiconductor (NSM) was reporting solid results. All was right with the world and everyone was buying. That was the peak. Since then, the markets have moved lower and have become oversold and Micron Technology (MU) reports a disappointing quarter and all is wrong with the world and everyone is selling. Could this be a temporary turning point as well?

I am careful to use the term temporary in the above sentence because I continue to believe that the after the perception trade (everything is oversold and things can't get much more negative), we have moved into the twilight zone trade (the news backdrop becomes more mixed and supply/demand in stocks is closer to equilibrium), before entering the reality trade (when there is too much enthusiasm and no matter what news comes out, it can only disappoint relative to expectations).

In the perception trade, the market indices and its components are oversold on both the daily and weekly charts using the 14-period stochastic indicator. In the twilight zone trade, the near-term overbought condition that resulted from the perception trade is worked off and the daily picture becomes oversold, but the weekly picture begins to turn negative and losses momentum. In the reality trade, the daily and weekly pictures rest in overbought territory and lose momentum.

The current environment appears to confirm the view that the market is in the twilight zone. This means that any additional rally should be viewed as an opportunity to raise cash and become more defensive in stocks because they have lost their intermediate-term (weekly) momentum and remain in a downtrend. Obviously more aggressive trading type can try to get a small trade out of a near-term (daily) oversold bounce, but I would certainly not marry any new purchases. Typically in a bear market, when the intermediate-term begins to lose momentum, the best-case scenario is for sideways action over the coming months.

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