The Sentiment Cycle

Anyone looking at a chart of stock prices can see that markets move in ebb-and-flow cycle patterns. In fractal-like fashion, cyclical patterns reveals themselves across various time frames--from granular minute-to-minute action to secular decade-long swings.

The nascent field of socionomics equates cycles with changes in 'social mood'--alternating periods of collective optimism and pessimism that cause investors to run with the pack (a.k.a. 'herd behavior').

Here is an interesting diagram that reflects various emotional states as a market cycle progresses. Note that extreme optimism is associated high risk. This is because euphoria has driven investors to bid up prices. At some point, extreme optimism reverses as do prices.

This model suggests that best value is obtained at lows in the sentimental cycle. Extreme pessimism drives investors to sell and to stay away from assets marked way down.

I personally find it useful to overlay these concepts on my fundamental analyses. For example, a question that I've been asking myself over the past couple of weeks is where on the diagram is general stock market sentiment currently?

We entered a bullish uptrend off the March 2009 lows. Since then, markets have been rising on increasing optimism. This has been a strong bull run, with major indexes like the S&P 500 (SPX) up nearly 100% off the lows. Now, however, the uptrend is more than 24 months old and general market valuations are extremely rich. Technically, we're approaching a level (SPX 1250) which, if decisively pierced, would reflect a trend change.

From where I sit, collective sentiment may have topped out at 'Euphoria' at the end of April (approx SPX 1370). Investors are currently at 'Anxiety' after a 7% decline from the highs. If correct, then we have more work to do on the downside. Stages of fear, panic, capitulation (e.g., 'forced selling') lie somewhere ahead. I have been trying to position accordlingly.

I'm not totally pessimistic, however, as some individual names have been beaten down to the point where the negative sentiment coupled with interesting fundamentals suggests value. Cisco Systems (CSCO) is one of those names.

Over the past few months, CSCO has reversed nearly all of its gains off the 2009 lows as recent quarters have fallen short of expectations. Sentiment in this name is horrid, and portfolio managers have been busy unwinding positions in CSCO as prices go down.

Our diagram, of course, suggests that extremely negative sentiment is likely to wring risk out of a security. Pessimism encourages selling over buying. All else equal, the lower the price of a security, the better the value.

I happen to believe that CSCO's competitive advantage is still intact and durable. Using similar reasoning to my entry into this name, I now think I can buy a large multinational company with a durable franchise, strong balance sheet, and $9 billion in free cash flow, that I conservatively value at $90 billion, for a market price of about $60 billion.

The risk, of course, is that the fundamentals of the company have been permanently impaired, and markets are in the process of revaluing the franchise.

Could be, but the current disparity (market says it's worth $60 billion; I think it's worth $90 billion), gives me a decent margin for error in my assessment.

position in CSCO, SPX