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Why the "Economic Recovery" Is a Trap

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When stocks explode on dwindling volume and suspect fundamentals, the risk of collapse rises.

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Editor's Note: The following is a free edition of Jeff Cooper's Daily Market Report. For a 2-week trial FREE trial, click here.

Let me live 'neath your spell
Do do that voodoo that you do so well
"You Do Something To Me," Cole Porter

"Crowds are defined by their shared emotional experiences, but masses are defined by their interpersonal isolation."
Vincent Price

"All economic movements, by their very nature, are motivated by crowd psychology."
Bernard Baruch

"In reading the history of nations, we find that, like individuals, they have their whims and their peculiarities; their seasons of excitement and recklessness, when they care not what they do….Money, again, has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."
Preface to Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay

Market professionals think that on the whole a profit season that exceeded 'a honey, I shrunk the expectations landscape' is likely to be followed better profits instead of lower ones. Either that or they believe that P/E's will expand. Those are the only two ways for stocks to go up--increased earnings or higher P/E's.

Or, mania..

Mania (from the Greek meaning "to rage, to be furious") is a condition characterized by extremely elevated mood alternating with episodes of major depression. In Electroboy: A Memoir of Mania, Andy Behrman writes: "When I'm manic, I'm so awake and alert, that my eyelashes fluttering on the pillow sound like thunder… life appears in front of you like an oversized movie screen."

Mania in an individual magnifies hope and desperation. Mania in a crowd is reinforced. Sigmund Freud's theory of crowd behavior revolves around the idea that people in a crowd act differently from those who are thinking individually. The mind of a crowd can merge to form a way of thinking. Individual enthusiasm in a crowd is increased as a result.

The mass mind of the market is subject to contagion and control. Fear breeds fear; greed breeds greed; momentum begets momentum. An object once in motion will tend to stay in motion. The question that cannot be ignored is whether purposeful propaganda or a real change in the facts has set the object of mass psychology in motion. Accurate or not, as traders we have to trade the figures given us -- but we don't have to buy into them hook, line, and sinker.

The more market participants buying in response to the way the news is shaped, the more believable the story becomes, and the more realistic a rally phase appears (and vice versa). It becomes difficult to distance ourselves from the beliefs of the crowd. The more media attention a story receives, the more attractive it is to market participants -- though it may be a mass psychological trap. We tend to attach ourselves to things and people that may be wrong in order to dispel uncertainty: Any attachment, right or wrong, feels better than uncertainty and the unknown.

Right now, fear is running rampant: Portfolio managers fear they're underinvested. Portfolio managers aren't just measured against the performance of the market but are measured on a relative basis against the performance of their competition as well. They do not have the same luxury of patience as individual investors. They're graded, like stocks, on a quarterly basis. Oftentimes, in the midst of a sharp and persistent rally, the fear of having missed the boat can be so overwhelming that it forces money managers to get in.

Of course, individuals may also feel compelled to act when the fear of missing out becomes overwhelming -- but their dirty laundry isn't in public like that of money managers, advisors, and letter-writers.

Often even those that identified a major turning point and recognized the onset of a major rally take profits and become sold-out bulls as the market fails to accommodate with a pullback where they can re-enter.

Often, a persistently aggressive rally will culminate in the capitulation of various camps:

1. Sold-out bulls capitulate to the idea of waiting for a pullback and rush in.

2. Big-picture bears cave in on their thesis, at least for the time being, retrenching to reassess.

This sense of frustration is often characterized by gap to a new high which subsequently elicits a lack of follow through implying that all the buying potential has already been realized.

That being said, significant tops and bottoms are never as unequivocal as a man being shot from a cannon in the circus. You get warnings by way of divergences (descending volume with rising prices and fewer new highs versus new swing highs in the popular averages) but these warnings are often met by disbelief as the market entices us not to heed them by heading higher. The market usually offers a graceful exit, but the precise timing of a top (or bottom) is elusive, leading most players to leave risk to randomness.
No positions in stocks mentioned.

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