I haven't found any better explanation or synopsis of this cycle than that provided by Teresa Lo of InvivoAnalytics. What follows is an excerpt from her book on trading entitled The Ultimate Trading Course. Teresa writes:
What we have (in Chart 14 of The Nature of Risk) is essentially a graphical representation of the manic depressive moods typically experienced by market participants as a function of time and price in one complete sentiment loop. There are two areas in a typical loop where the market does something that traders describe as "churn" or "chop", and two areas where directional trends are found.
RETURNING CONFIDENCE
On the upside, the area where churning takes place is in between the Returning Confidence phase and the Subtle Warning phase, after a significant advance has already taken place. This often appears in the form of a head and shoulders top on weekly or monthly charts. By the time confidence returns, the market has already been going up for ages while the retracement patterns become ever larger, each one scarier than the last.
To technical traders, this type of price action tells us that the market is getting tired. Perceived bull market volatility excites investors. They waited forever on the sidelines for fundamentals to confirm that the move up was "real". The coast is finally clear and they jump in with both feet. This phase typically ends with a failure on test of top, and the big, super scary "buy the dips" pullback begins.
BUY THE BIG DIP
The public continues to pour money in, lured by glowing good news and economic data. After the long move up, finding attractive stocks becomes difficult for technical traders and market veterans. Traders chase momentum where they find it. Investors believe that the game is back on, and they are willing to take big risk and buy big dips. This Big Dip usually comes after a failed test of top in the Returning Confidence phase. The Big Dip typically takes price below the 50-day simple moving average and quite often, to the 200-day moving average. This is where ABC Corrections are typically found.
ENTHUSIASM
Once it is widely accepted that economic and corporate fundamentals are supporting higher prices, a bell goes off. The bull survived The Big Dip. Those who had previously been afraid now have plenty of reasons and "proof" that it is safe to go back into the market and buy again.
At this point, we detect a subtle change in psychology, a shift from the fear of loss to the fear of missing out, and the appetite for risk becomes evident. Investors buy on faith, bolstered by analyst and media reports projecting the trend to continue. As price rises to new highs, they all scream, "It's a breakout!". They are supremely confident that the best is yet to come.
The high made in the Returning Confidence phase typically marks the "point of breakout" and becomes an important psychological number. We know this high is where sellers showed up before, and if price should sink below this area, traders and investors might come to the conclusion that the breakout failed, and therefore, begin selling in case the uptrend is approaching the point where it starts to bend.
At some point, all the buyers who want to be in the market have bought, and they stop buying. Smart money begins to take some off the table. The net result is rotation of buying and selling from sector to sector, causing the major stock indexes to stop going up in any meaningful way and price charts to churn and chop. In the old days, they called this "distribution", marking the transfer of stock from smart to dumb money, from strong to weak hands. This area is where a buildup of participants in position to write sell tickets takes place. If price fails to move up or it comes back under the point of breakout, selling begins.
DISBELIEF
The market fails to go higher, and indeed many of the early leaders have broken down under the 50-day moving average, giving technicians the Subtle Warning. This marks the beginning of the "something is not right" gut feeling, but in the absence of bad news, investors hold on to hope. Not only are they heavily invested in the market, they are psychologically invested in being right and they ignore anything that does not go with their worldview. Indeed, they even wonder aloud why their beloved stocks cannot go up amidst good news, higher earnings guidance and analyst upgrades.
OVERT WARNING TO PANIC
The area of sustained directional trending price action to the downside takes place is between the Overt Warning and Panic phases. There will be some sort of catalyst. Perhaps it is an earnings warning or some point of economic data that leads the crowd to finally clue in that the nagging negative price action they have been watching is the beginning of something big and bad.
The 200-day moving average is broken, and CNBC alerts investors. Everyone knows that the ship is sinking. Those who bought in the churning top realize they are holding the bag and stop buying the dips. Smart money shorts each failing bounce. Stop losses are hit, and margin calls force liquidation. Supply simply overwhelms demand and price action becomes a one-way street.
DISCOURAGEMENT AND AVERSION
After a long price slide, the area where churning takes place is between the Discouragement and the Aversion phase, after a significant decline has already taken place. Often, this appears as a head and shoulders bottom, a cup and handle or a saucer dish pattern. As the public continues to dump stocks, short sellers become bold and bearish. Their views are supported by bad news and poor economic data. Prognostication of lower prices to come is undoubted. This is when everyone knows that the market cannot ever go up again, and that anything, even cash, is preferable to owning stocks.
WALL OF WORRY
While the broad indices are still going down, certain sectors will have bottomed. At some point, everyone who wants to sell has done so, and the selling stops. Low prices and relative value returns, and early buyers with deep pockets begin to nibble at the market. The net effect is that the major stock indexes stop plunging and begins to dribble or moves sideways.
This area is where we find a buildup of participants in position to write buy tickets, producing potential buy pressure. With sellers gone, the market even goes up on bad news. Rallies are labeled as "technical bounces" or are written off as "short covering" Short positions add more on every bounce, confident that lower prices are around the corner. When good news trickles in, it is summarily dismissed as aberrations, subject to revision next month.
AVERSION TO DENIAL
Sustained directional trending action to the upside begins between the Aversion phase and the Denial phase. As the market slowly creeps up, the shorts start to sweat while those who don’t own a piece of the action vow to themselves that they will get in on the next dip that they believe is sure to come. The market continues higher and does not let them in.
More and more bids materialize as buyers show up again while shorts begin to cover. Since there are not many sellers overhead, the move up can be big and fast, and on low volume. If it keeps going, eventually those left behind in the dust have to get in again, and the loop continues.
What, Mark, does this have to do with investing, you say? It turns out that Mamis Sentiment Cycle dovetails nicely with Warren Buffet's maxim to "Be fearful when others are greedy and greedy when others are fearful", doesn't it? The best returns are not made from high valuations on stocks (after lengthy bull markets or strong upward moves in bear markets) but when shares are being thrown away by others. You don't buy chicken at $5 a pound when you know the store will have a sale that weekend for $2 a pound do you? Why are stocks any different?
In any event, Grantham and Hussman (two investors I highly respect) both said in March that stocks had become UNDERVALUED. For about the first time in 20 years. THAT was the time to buy. Now stocks are slightly overvalued by most measures. It's time to be patient and wait for the next opportunity.
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