Investors, like any other group of people, can get set in their ways. Once they become used to a specific mindset, they can become very slow to adapt to a change in either market trend or broad investor sentiment.
Call them slow to change Memes.
We’ve seen that “slow to adapt” behavior several times over the past 3 years. Just as every general fights “the last war,” investors, too, tend to lag reality, often getting mentally stuck in the previous trading cycle. When the bear market began in March 2000, many players on the long side continued to buy the dips. On the flip side, short players have been similarly getting punished since the March 2003 reversal. The failure to adapt to changing market conditions invariably leads to major trading losses.
Much of this slowness to adapt to shifting circumstances is traceable to a simple psychological factor: Recent events have far greater resonance for people than do older incidents. Indeed, its been demonstrated that close proximity in time to major financial gains or losses has a significantly disproportionate affect on the human psyche, often lasting for many years. The more recent a market event occurs, the greater the influence it will have on an investor’s subsequent trading methodologies.
We suspect this dynamic is what’s behind the early October lift off. Once the month of September ended – down a mild 2% – the bear’s best hope for a seasonal rally failure ended. The new quarter gave the significantly short hedge fund community an opportunity to switch teams. As some of the recent market internals reveal, it appears many previously short or under invested firms did just that. The high volume, advance/decline breadth thrust we saw last week, along with the strong up/down volume of today, suggests that institutional money is finding its way off the sidelines and into the long side.
That mad dash into the market this quarter has led the indices to an overbought condition. In fact, today’s exhaustion gap up after the long rally likely suggests a form of buying capitulation. Although we believe the market will be somewhat higher by January 2004, we would be looking for more advantageous entry points than present levels.