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These enormous pendulum-like swings indicate that the law of action and reaction for market activity is very much in force. The longer a psychological trend takes to build, the greater the magnitude and duration of the corresponding change in sentiment is in the opposite direction.

To demonstrate this concept I overlaid the numbers and letters from Chart 1 on to Chart 2. It took the 8-year bull market in the 1920’s to build up the drunken euphoria that was present at the 1929 top. The actual low was seen three years later in 1932, but the psychological damage, in the sense of people expecting the other shoe to drop, continued for decades. It took about 2½ generations before confidence was fully restored and the market was able to begin the bull trend of the 1980’s and 1990’s. In terms of prices, it was not until the mid 1950’s that the 1929 peak was surpassed. It’s also interesting to note that a substantial, and long- lasting, bull market followed each period when the Price-Earnings Ratio was exceptionally low.

Chart 2.

You may be thinking investors got off lightly following peaks A and C, since the market resolved its corrective period with an extended trading range rather than a sharp 1929/32 type decline. However, when equity prices are deflated by commodity prices, we can see the real damage that took place. This is shown in Chart 3, where the numbers and letters from Chart 1 have been overlaid on “real” stock prices.

I’m sure you can now appreciate that the 1900/1921 period was an exceptionally bearish one, especially towards the end. So was the 1966/82 period, although the actual peak in this inflation-adjusted series was 1968. The 1929/49 period is also an interesting analysis. The actual low developed in 1942, although the 1949 bottom was not much higher. In effect, the whole bearish inflation-adjusted trend lasted twenty years, the longest on record. The 2000 peak in the P/E Ratio was the Stock Prices highest, and most distorted on record. If the past is a prelude to the future, it’s unlikely that real stock prices will see the levels attained in 2000 until well into the 2010/20 period.

Chart 3

Finally, the Stock/Commodity Ratio broke below its secular up trendline in May, 2006. There are only five periods when it is possible to construct a meaningful trendline since 1800. This is a very important event because the average drop following a secular trendline break in this Ratio is around 60% and lasts roughly 8 years.

It’s a little known fact that there’s definite correlation between sentiment and momentum measures, or “oscillators”. (To learn more about oscillators, peruse Momentum Explained, Volume I.) This means we can use the momentum of stock prices as a substitute for sentiment when sentiment data is unavailable. For example, you can see that prices (psychology) have moved too far in one direction by plotting the annual level of equity prices against a trend deviation indicator. The indicator in this case is a 12-year moving average (MA) divided by a 3-year time span. Charts 4 and 5 display what happens when the data of the two averages are identical; the oscillator is plotted at zero. Since we’re using annual data, we’re not expecting precise timing, but the indicator’s peaks and troughs nevertheless offer useful benchmarks of the market’s long-term temperature.