Saturday, August 25, 2007

Rally Happened, Now What?

The stock market rally I predicted on August 17th came to pass. How did I know it would happen?

First, let's recap the action. The US market is up 2.5% or so (the biggest one week gain in 4 months) since the prediction, the Hang Seng was up 12% last week, and the Kospi (Korea) and Bovespa (Brazil) were both up 9%.

So how was it clear to me that the market would rally for a week? Well, there was a definite sense of panic on the prior Thursday. Jim Cramer's doom-filled rant on Erin Burnett's CNBC show is one obvious example. Watch Cramer lose it here on youtube.

When the panic was over, there was a end-of-day rally -- the first positive sign. Then there was relief when the Fed dropped the discount rate 1/2% -- indicating that the Fed would bail out the markets if need be. That relief gradually spread and encouraged panicked traders to buy back in, prompting shorts to cover, and a rally ensued. Psychologically, if traders are not at peak fear (risk aversion), they are less risk averse (leading to greater buy pressure). Even when they are afraid (but no longer panicking), then the market will rally. It's all about levels of risk aversion relative to their recent extremes.

If another negative event had happened (some small ones did), the market wouldn't have fallen as much because the short-term players were already scared out. It would take a major event to convince the long-term money to sell.

On an individual basis, I know many traders and fund managers had difficulty staying long on that Thursday (August 16th). Most portfolio managers knew it was a good time to buy (as every asset manager has learned, it's a great time to "buy when there's blood on the streets"). But without long experience and tremendous courage, it is extremely challening to emotionally hold the line during such periods. My book Inside the Investor's Brain: The Power of Mind Over Money (Wiley Trading) has some tips for practitioners during market panics.

Happy Investing,

No comments: