Sometime ago I wrote a blog entitled The Peltzman Effect in the markets. It examined the effect of safety systems lulling as into a sense of complacence that either makes us take bigger risks or makes us complacent about events continuing endlessly. 2017 was one such year where the public was fed on a diet of every rising market. The reactions were so small (3% max) and the rebound from those so swift and strong that people began to take ever increasing risk with their quantity (particularly in small and mid cap stocks) and looked upon every pullback as yet another buying opportunity. The out performance of the small and mid cap indices over the Nifty reached epic levels but instead of creating some disquiet, it fed the greed.
So, the reaction in Jan 18 was seen in a similar light. The first drop was like many before it- falling about 4% from the high. Right on cue, the bulls were back, carrying the index back up. However, this time the rise could not carry to a higher high- like it happened every time before. When the first low was broken by end Jan 18, the Peltzman effect was still on full force and people did not realize that the main trend was changing.
Maximum loss occurs when the main trend changes. Most people are still caught up in the old trend and hence do not willingly see the change even if it is apparent to them. The mind wants to believe the former pattern, the environment is still full of people talking about the recent good times and all the better times that are coming ahead. In that situation turning a contrarian is a very, very difficult job.
Is there a way to avoid getting trapped in the Peltzman effect? Simple technical analysis rules followed diligently can provide the solution! In the example cited above, the lower top was formed in mid Jan and the first lower bottom was formed at end Jan 18. By then the correction had gone deeper (more than5%) and lasted longer in time than all the previous ones in 2017. Gann calls it an overbalance of price and time. These two simple rules – one Dow theory and one Gann swing- would have been sufficient, along with an awareness of the Peltzman effect to warn us of what was happening!.
What is happening currently may be a sort of reverse-Peltzman effect, if I may take the liberty of coining such a term. Continuing to remain locked into the 2017 sentiment and continuing to believe the “story” for which they bought a stock, most investors have seen their portfolio value plummet by 30-60%. The fear element now is so high that people are perceiving risks that don’t even exist! The recent State election outcomes almost paralyzed the investor community. This will now prevent them from buying the dips- which they had planned on doing all along!
A right reading of what the market is saying, using technical analysis in the correct manner, will release us all from these periodic bouts of euphoria as well as depressions.