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Dorn: Fear and Greed in Rallies and Bull Traps

These are unprecedented times. The markets are showing their true animal nature because they are trading on emotions, rather than on technicals or fundamentals.

Even the most seasoned market veterans are scratching their heads. Where is the rally? What are people waiting for? What about the “dirt cheap” valuations on a number of stocks? What about the extreme sentiment of doom and gloom? Bullish sentiment is now the lowest since the summer of 1994, so where is the contrarian sentiment reaction? What about the “big boys” stepping up to the plate to buy here? What about the new and unprecedented global rate cuts? What about the old adage about buying at Yom Kippur and selling at Rosh Hashanah? Where? What? Why?

Despite the fact that the broad markets are massively extended to the downside (the Dow industrial index is now more than 2000 points below its 200 period moving average), we are not there yet. The action Wednesday showed that the selling is not yet exhausted. In fact, it did what the clever bear does—it gave a ray of hope to people. IBM movement to the upside after the close gave a lift to the futures that could be good for a positive start to the day on Thursday. Citigroup and Wells Fargo may settle their dispute over Wachovia soon, and this may help by removing some uncertainty from the markets.

Will these be catalysts for a massive rally? We shall see, and I will believe it when I see it. One thing I do know is that, when this rally comes, it will be powerful because the rubber band to the downside is pulled so tightly that it has to snap soon. Also, it will give people hope that the worst is over, and they will begin to pile into the markets again once their post-traumatic stress disorder (from selling at the bottom) is resolved. By the time this happens, it will be near the end of the up move and it will look so good and tempting that they will then be clamoring to get in. This is how bear markets work. The tables are turned. The bear sets traps for us instead of the other way around. The bear sets bull traps to catch greedy bulls. Behavioral finance tells us that the majority of traders will be greedy when they should be fearful and vice versa.

We have not seen a true gap down and reversal, indicating that the last of the sellers could no longer take the pain, cried “uncle” and wanted out at any price. This is what people want to see, and they are not getting it. It may not come, but it does appear that there is enough fear to ignite a spark for the next rally. Now is the time to prepare for this and we don’t have to be right there when it happens. We will give up the first 10% and the last 10% of the coming rally to get the middle 80%. Why? Because we don’t like to be stabbed by trying to repeatedly catch falling knives and go through the psychological torment of getting in, getting stopped out, getting in again and getting stopped out, etc. It is too taxing and draws down on both financial and psychological capital.

The rally will come out of the blue when people are just so worn down and sold out that they stand in awe, disgust and regret when they see it. We are overdue in price, and just about right in time for it to happen. Like a watched pot that never seems to boil until you walk away, the rally will catch most people by surprise. In terms of Elliott wave (for all the wavers out there), this will likely be a “B” wave rally that could take the S&P up to 1290 over the next few months. No one really knows for sure when, but we will know it when we see it and we will do one of four things—depending on our position in the markets when it happens. (1) trade with longer time frames, especially if we can catch a trending market ;(2) use this rally to sell all underperforming assets (3) hope that we are lucky enough to catch the middle of this move (4) continually remind ourselves to be in touch with our feelings of greed and fear so that we have courage to get in when it feels a little uncomfortable, and start taking money off the table when it looks and feels safe and comfortable..

Until Next Time,

Good Trading and Brain On!

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Janice Dorn, M.D., Ph.D., is a financial psychiatrist and chief global risk strategist for Ingenieux Wealth Management in Sydney, Australia. She also offers trading consulting and coaching services via her Web site, TheTradingDoctor.com.