“Every truth passes through three stages before it is recognized: In the first it is ridiculed; in the second it is opposed; in the third it is regarded as self-evident.” – Schopenhauer
Typical market uptrends go through three main sentiment stages:
1) “What bull market? The fall is right around the corner”
Most of the signs of an uptrend are already here – money is leaving defensive names in order to chase higher yield, breadth is improving, correlation and volatility decline substantially. Despite of that, many people don’t believe the rally and prefer to short “overbought” names, only to get squeezed by the tidal wave of monstrous accumulation.
The fastest price appreciation happens in stage 1 and stage 3.
2) Acceptance stage
More and more people gradually warm up to the idea that we are in an uptrend and the market should be considered “innocent until proven guilty. Stocks have been going up for awhile and the minor dips were short lived.
Between stage 2 and stage 3, there is usually a deeper market pullback, which tests the resilience of the rally, shakes weak hands out and allows for new bases to be formed. The deeper pullback is used as a buying opportunity by institutions, which missed the the initial stages of the rally and their purchases push the market to new highs.
3) Everything will go up forever
During stage one, most people are skeptical, because the market has just come from a high-correlation, mean-reversion environment and most are unwilling to see the ensuing change in market character. In stage two, investors gradually turn bullish for the simple reason that prices have been going up for a while. Analysts and Strategists are also turning bullish in an attempt to manage their career risk. In the third stage, most market participants are ecstatic, not only because prices have been going up for a while, but because they personally have managed to make a lot of money. Everything seems easy, the future looks rosy and complacency takes over proper due diligence.