The mood of the stock market, manic and upbeat for most of this year, might very
well be transitioning to a more depressing, downbeat state of mind.
That's the diagnosis from Woody Dorsey, a self-described "master of market psychology." Dorsey is president of Market Semiotics, a research firm that analyzes the market's manic-depressive behavior from a psychological viewpoint from the picturesque town of Castleton, Vt., a 243.3-mile drive from Wall Street's frenetic trading floors.
In many ways, Dorsey is a market "shrink." He analyzes what the market's state of mind is during its many cycles. His goal: decipher if the market is in stable condition and a good state of mind, or whether it is starting to exhibit signs of unstable behavior that point to a breakdown.
His line of work is especially helpful during periods like now, when both stock prices and investor sentiment appear to be at, or nearing an extreme. And where price swings start to get wild, as they have in the Dow Jones industrial average, which has seen 100-plus point moves in 17 of the past 18 trading sessions.
It is during major extremes when markets tend to change direction most dramatically. And right now the stock market, after racing ahead 15% this year, its fastest start since 1987, is still trading near records. And investor optimism has been on a steady rise, becoming more exuberant.
The combination of a hot market and a growing herd of believers in the rally could be adding up to trouble, Dorsey warns. The market's flagging momentum the past few weeks since the Federal Reserve hinted it could soon start paring back on its market-friendly bond-buying program, coupled with growing volatility both in U.S. markets and foreign markets like Japan, could be signaling that stocks might be carving out a top and the long-awaited pullback is underway.
Dorsey's diagnosis: "The market is in the late stage of a mania. There could be more gains to come. But the resolution will be a very severe correction. And I think it will happen in the next few months."
So what symptoms worry Dorsey?
--Bullish storylines. The market has been melting-up, thanks to a series of bullish and recurring story lines, or what Dorsey calls "rationalizations" for why stock prices will keep rising. The script includes concepts such as the notion that central banks will "do whatever it takes" to ensure the market won't suffer a 2008-style collapse.
Another popular meme is the notion that with interest rates, or yields, on cash and bonds at or near historic lows, there is no other place for investors to put their money. This is the so-called "TINA" trade, or "There Is No Alternative" to stocks, coined by investment firm Strategas Research Partners.
Similarly, there's the FOMO, or "Fear Of Missing Out" trade. That is the belief that if you're not invested in stocks, they will miss out on gains. Or the belief that it's a no-brainer to own dividend-paying stocks. Or Japanese stocks. Or that interest rates will never rise again.
Dorsey says these themes are similar to the go-go 2000 tech-stock era. Or the 2007 period when everyone thought home prices could never go down. Or the exact opposite of 2009 when investors were gripped by the "fear" story line and thought stocks would never rise again.
As a result, "You have this whatever it takes, stocks are the only place to be, you-can't-lose mentality," Dorsey says. The problem: It creates a big extreme in prices, which increases market risk. In short, "People can see only one side of the equation," says Dorsey.
--History-making moves. Record highs in the stock market, by their nature, are historic. And what is historic is very unusual. The fact that central bankers around the world have cut interest rates 515 times in the past six years, according to Bank of America Merrill Lynch, is also very unusual. As is the fact that stocks are off to their best start in more than 25 years.
"It is an outlier," says Dorsey, adding that rare occurrences also have consequences that are unpredictable.
--Parallels to past drops. Dorsey is not predicting a crash, but rather an extreme re-pricing of stocks or a severe correction. He says there are parallels to 1987, when stocks famously crashed. Back then, yields on the 10-year Treasury note rose sharply, from around 7% at the start of the year to 8% and then 9% that summer as stocks kept rising. By the time the Dow crashed that October, the yield on the 10-year Treasury note had topped 10%.
Investors, of course, are currently worried again that rates will rise sharply in anticipation of the Fed dialing back in its bond-buying program, which has been in place for more than four years and which has pushed down rates artificially. The 10-year note last week topped 2.2%, up from around 1.64% in May.
Dorsey says the stock market is in a bubble. He says the risk is that "when the market turns, everyone has to get out because there is no one else to buy."
For that to happen, he says, you need a change in investor sentiment, a change in the direction of stock prices and the realization that the market has a new "story" driving it.
"When people realize something has changed, that is when they will decide to sell," says Dorsey.
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