back to blog homepage

Change in Character for S&P?


I like the visual aspect of looking at graphs to give me a feel for what is really happening in the markets. There are two aspects to stock market prices: earnings and psychology. Earnings are fundamental to a company and its stock price – all else being equal, a stock price goes up as its earnings increase.

But we all know, all else is never equal. And the thing that makes it so is investor psychology. If investors are feeling positive about the future, psychology is positive and they are willing to pay more for growing earnings (this results in a growing P/E ratio). However, if they are feeling negative about the future, they are willing to less for growing earnings (this results in a contracting P/E ratio).

During a bear market, investors are decisively negative and they are not willing to pay for earnings. They use any opportunity to sell rallies, P/E ratios contract, and prices go down. Volume tends to decline on rallies until prices get to the point where investors decide to sell, then volume increases as selling dominates the landscape.

However, there comes a point where the psychology starts to turn and investors are willing to put their money to work in spite of prices increasing. When this happens, you start to see volume increasing on rallies and buyers willing to buy stocks in a market with rising prices. This change in psychology is important and can lead to very strong counter-trend bear market rallies, and even new bull markets.

In looking at the graph above, you can see that I’ve drawn in some diagonal red and green trend lines near market rallies with their associated volume levels below. This graph traces the course of the bear market from late 2007 to present and you can see the downward path with periodic rallies, the bottom made this past March, and the rally to today.

What is interesting to note and may give us a clue to investor psychology is the trend lines. You can see the the red lines show declining volume during every rally we’ve had during the bear market until the current one. The current rally actually shows investors moving money into the market and volume increasing as prices go up.

This is a pretty key change in psychology and could mean that we are due for a move higher. Only time will tell whether this market will in fact move higher since the newest entrants to the market will be the most skittish and be the first to sell – they missed the early part of the move and will not be patient with any bumps in the road. However, if the trend in volume continues increasing as prices rise, then investor psychology has changed we can expect prices to rise up to our next target for the S&P 500 index, 1050.

I’ll keep you informed as this market continues to move.