Unexpected Fundamental Pressure
When a price trend starts, it is usually already running late relative to the fundamentals—in all probability it will be lagging behind the fundamental economic reality. Rather than preempting the future, markets are usually preoccupied with simply trying to figure the future out, and often in a quite emotional way. At the start of a new trend—for example, a bull trend—it is usually the case that the fundamental forces have already shifted in real time, but the market has been busy overshooting the previous bearish reality. But once the market crowd recognizes the new dominant fundamental forces, it has to do two things: first, get out of the now-unjustifiable short (that is, sold) positions it is holding because of its previous bearish beliefs, and second, actually buy so as to get long and try to take advantage of the bull swell in the offing.
True Believers Reassert
Once everyone who believes in the new paradigm takes a position, there will appear to be a pause in the trend before it proceeds. Now, remembering these are early days in a new trend and many participants will see this upward movement as a bounce in a bear trend rather than a fresh bull trend, those who are bearish may misread the price hesitation and decide to sell again. This will, naturally, lead to a down move. This movement can be severe, and price can often go all the way back to near the starting point (the absolute low) that had preceded the start of the new bull trend.
Everyone on Board
The new fundamental paradigm is in full swing, however, and the same forces that were pushing the market higher due to the imbalance in supply and demand again begin to dominate. As the market moves higher this time, the psychological impact is magnified and becomes much more powerful. The buyers are greatly encouraged as the previous low holds and begins to look like a handy support point (and a double bottom for any revisionist technical analysts out there), and the bears are discouraged at the failure of the market to break to new lows as they had expected. Now we have a market that is psychologically or emotionally leaning to the upside, overlaying a bullish fundamental reality. The converging of these two currents (fundamentals and emotions) can create the most powerful move to the upside of the whole trend, but there is a lot more still to come.
As this very fast uptrend continues, more and more participants have greater confidence in it. Even fringe-dwelling market observers, such as everyday mom-and-pop investors, may eventually be drawn into the excitement.
Exhaustion Consolidation
At some point, however, it is inevitable that, despite the immense size and nature of modern financial markets, the finite number of participants who can sustain the buying pressure will simply run out. This leads to an exhaustion phase. This phase is when basically everyone who could possibly want to buy into this stock or market has already done so. There is simply no one left to buy. In such circumstances, it does not matter whether any fresh news is bullish or not, as there simply is no one left to buy. The market, unable to sustain itself, now begins to fall back on any selling that occurs as a normal part of the market, with sellers looking to recoup funds for all manner of reasons.
As the market approaches this exhaustion point, it simultaneously reaches the maximum potential energy to the downside. The potential energy to the downside is a direct consequence of all the buying that has been done—some for real business purposes, but the most significant portion for speculative purposes based on the bullish emotions that were flowing at the time and the perception that this would materialize as capital appreciation.
Speculation is, of course, successful only when unrealized profits are made concrete through the closure, or the sale, of those positions. Thus, the more buying that has been done into a market, the greater the potential energy to the downside should there be fresh bearish news or should simple market exhaustion occur.
Added to this is the potential for significant selling pressures as speculators race to realize profits. It is worth noting here that the underlying fundamental forces to the upside have not altered one iota during this period; however, the market continues to move as a result of the emotional energy that flows from the interaction of people who sustain it. All that has happened is that, first, market participants have recognized the new bullish paradigm and got more and more wound up about it as the market continued to move higher.
After the exhaustion, however, a high degree of confusion usually emerges. For the latest arrivals, there will be losses on bought positions. There might even be some short sellers who begin to make small profits again. It is this state of discord that results in what is usually the most drawn out, and quite choppy, price action of the whole trend.
Final Overshoot
The bull trend has not yet concluded, however. The underling bullish fundamental forces are constantly, gradually, readjusting the balance, recovering the balance, and then relentlessly shifting the net pressure again to the upside. Once again, the nonbelievers convert and the market participants begin to buy aggressively. They have made money before from being long and so are now quick to get on board again. Typically, this movement results in the last sharp overshoot to the upside.
The market continues to gather momentum to the upside until ultimate exhaustion is in place and/or the fundamental forces have again returned to the downside. Indeed, it is sometimes the case that the overshooting nature of the market to the upside can swing the underlying fundamental forces to the downside. This is because the market can also be shown to have a cause relation to the fundamentals of which it is often the effect. At this point the whole process may begin again to the downside as a major bear trend. Alternatively, it could simply be a period of hesitation on a grander scale, of a greater quantum, to that which followed the penultimate exhaustion high.
Read More: Anatomy of a Trend
