From the October 01, 2012 issue of Futures Magazine • Subscribe!

Sentiment: Putting trading into context

Breaking expectations

The second half of 2011 didn’t follow the consensus. Not only did the White House and Congress play Russian roulette with the debt ceiling, but European equity bears lost billions predicting the Greek crisis would be the next Lehman moment.

There are many lessons to be learned. A wall of worry transforms into complacency; that’s one way sentiment clues us into a peaking market. But the sooner it morphs into irrational fear, it’s an indicator the bear phase can be close to an end. The scars of 2008 influenced the correction of 2011. In 2011, bears were anticipating Greece would bring down the market; it never happened. 

The market has few, if any, universal truths, but this comes close: A panic and ensuing crash happen because of unanticipated events. By 2011, European banking and political officials were prepared for the crisis; therefore, it never turned into a panic or crash.

Another element to this market was the state of energy costs. It is common for concerns about supply to drive up oil prices. However, this, too, must be taken in the context of sentiment. Oil prices skyrocketed in 2005 when Katrina menaced the Gulf of Mexico. The actual fear that oil rigs would be destroyed was much worse than what actually happened. This might suggest to some that oil prices should have gone through the roof during the BP disaster in 2010, when millions of barrels seeped into the Gulf, complete with heart-breaking photographs of destroyed beaches.

The difference this time was context. Katrina materialized during a bull phase in equities where traders were fixated on supply concerns in a good economy. During the BP crisis, markets had peaked in April 2010 and at the sight of wildlife covered with oil, the crowd considered alternative choices of energy. Demand destruction concerns turned to panic, and the oil market crashed. Because the equity market spends more time in a bull phase as opposed to a bear phase, traders are more likely to fixate on supply concerns as opposed to demand destruction. This is why crude oil sentiment often is a reflection of stock market performance.

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