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Market Psychology: Is the Market Rational?
Investors use sophisticated tools to analyze markets.
However, there are always unexpected outcomes that
cannot be predicted by simply looking at the fundamentals.
Behavioral Finance is the science which explains why
market participants act contrary to rational market theory.
Dennis Gartman once said:
“The market can remain illogical far longer than you or I can remain solvent.”
Supply and demand is the fundamental
concept that determines the price in most
markets.
However, this proven and rational method is
NOT effective in determining stock prices.
Why?
Practical Personal Investing, Session 6, presented by Greg Shtock
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Investors buy stocks in anticipation of their prices going up. Anticipation is an emotion
involving excitement or anxiety. Do fundamentals or emotions drive the stock market?
Many times markets and stock prices move significantly up or down without
any change in the fundamentals. The reason: change in investors’ sentiments.
The “Market” is a group of people acting based on their beliefs.
Therefore, emotions drive the stock market.
Behavioral Finance studies the effects of emotional factors on
economic decisions.
Technical Analysis studies price patterns that are affected by
investors’ behavior.
Practical Personal Investing, Session 6, presented by Greg Shtock
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How many times have you thought that the market is
irrational?
Former Federal Reserve Board Chairman, Alan Greenspan,
often used the phrase “Irrational Exuberance” to describe
the financial markets.
We all know that we should be disciplined and rational. However, we act based
on our emotions rather than logic. Why?
If emotions are bad, why do we have them?
Charles Darwin believed that our emotions help us survive, thrive, and avoid
danger.
 When we are angry, we are likely to confront the source of our irritation.
 When we experience fear, we are more likely to flee the situation or threat.
 When we feel love, we seek out a mate and reproduce.
Emotions serve an adaptive role in our lives by motivating us to act quickly and
take actions that will maximize our chances of success.
Example of an injured man who could not leave his bed.
Studies of human body energy and the brain function.
Practical Personal Investing, Session 6, presented by Greg Shtock
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The fight-or-flight response is a physiological reaction that occurs in response to a
perceived harmful event, attack, or threat to our survival.
The autonomic nervous system acts unconsciously and regulates heart rate, digestion,
respiratory rate, pupillary response, urination, and sexual arousal. This system is the
primary mechanism in control of the fight-or-flight response.
During a threat to our survival, activities of non-essential organs, including our rational
mind, are reduced. Blood flow is redirected to only the essential organs and muscles
required to fight or to flee.
However, millions years of evolution has not provided our autonomic nervous system a
plan on how to deal with modern stresses such as losing money in the markets.
Perceived threat and/or mental stress result in a similar pain level as if it were a real
physical pain.
Practical Personal Investing, Session 6, presented by Greg Shtock
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Two people who are standing at different places looking at the
same thing will see the same thing differently.
People raised in different cultures see things differently.
People of the same culture who have had different experiences
while growing up will see things differently.
Example of two men and a dog.
Example of a basketball game.
http://www.youtube.com/watch?v=vJG698U2Mvo
Every time you buy an investment, there is someone
who has decided to sell it to you.
You have a good reason to buy; others have a good
reason to sell.
Practical Personal Investing, Session 6, presented by Greg Shtock
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Citi's Panic/Euphoria model has a pretty extraordinary track record of predicting returns.
It is a contrarian indicator, which means a “euphoria” signal is bearish and a “panic” signal is
bullish. According to Citi, the model's components include “NYSE short interest ratio, margin
debt, Nasdaq’s daily volume as % of NYSE volume, a composite average of Investors Intelligence
and the American Association of Individual Investors bullishness data, retail money funds, the
put/call ratio, CRB futures index, gasoline prices and the ratio of price premiums in puts versus
calls.”
Currently, the model is dangerously close to euphoria territory, reaching its highest level since
2008. “The Panic/Euphoria Model is sending a clear warning sign of substantial complacency,”
said Citi's Tobias Levkovich in a note to their clients.
Practical Personal Investing, Session 6, presented by Greg Shtock
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Definition of ‘Sentiment Indicator’
A graphical or numerical indicator designed to show how a
group feels about the market, business environment, or
other factor.
A sentiment indicator seeks to quantify how various
factors, such as unemployment, inflation, macroeconomic
conditions or politics, influence future behavior.
Investopedia explains ‘Sentiment Indicator’
Sentiment indicators can be used by investors to see how
optimistic or pessimistic people are to current market
conditions.
For example, a consumer sentiment index that shows
pessimism may make companies less likely to stock up on
inventory because they may fear that consumers will not
spend.
Practical Personal Investing, Session 6, presented by Greg Shtock
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The Consumer Sentiment Index is a consumer confidence index
published monthly by the University of Michigan and Thomson Reuters.
The consumer confidence measures were devised in the late 1940s by
Professor George Katona at the University of Michigan. They have now
developed into an ongoing, nationally representative survey based on
telephonic household interviews. The Index of Consumer Sentiment
(ICS) is developed from these interviews.
The Index of Consumer Expectations is included in the Leading Indicator
Composite Index published by the U.S. Department of Commerce,
Bureau of Economic Analysis.
http://en.wikipedia.org/wiki/University_of_Michigan_Consumer_Sentim
ent_Index
Practical Personal Investing, Session 6, presented by Greg Shtock
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CONSENSUS Bullish Sentiment Index
The Index is intended to provide indication of potential market directions. The
theory of contrarian opinion holds that when a predominant number of market
analysts are bullish, it is quite likely that the market is approaching an overbought
condition, and that a reversal in trend may be imminent.
CONSENSUS identifies the 75 percent level as the overbought level and the 25
percent level as oversold level.
The current reading is at 66%. See http://www.consensus-inc.com/hotline.htm
Practical Personal Investing, Session 6, presented by Greg Shtock
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The American Association of Individual Investors (AAII) is a nonprofit education publisher
that has been successfully aiding “do-it-yourself” investors for over 30 years.
Practical Personal Investing, Session 6, presented by Greg Shtock
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Sentiment Survey Past Results
Reported Date
Bullish
Neutral
Bearish
March 6
40.51%
32.86%
26.63%
February 27
39.69%
39.18%
21.13%
February 20
42.22%
35.00%
22.78%
February 13
40.15%
32.51%
27.34%
February 6
27.90%
35.70%
36.41%
January 30
32.18%
35.06%
32.76%
January 23
38.12%
38.12%
23.76%
January 16
38.99%
39.52%
21.49%
The sentiment survey measures the percentage of individual investors who are bullish, bearish,
and neutral on the stock market short term; individuals are polled from the AAII Web site on a
weekly basis. Only one vote per member is accepted in each weekly voting period.
Practical Personal Investing, Session 6, presented by Greg Shtock
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Excerpt from Barron’s Magazine ( http://online.barrons.com/home-page)
Practical Personal Investing, Session 6, presented by Greg Shtock
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Book by Mark J. Douglas
Chapter 5 The Dynamics of Perceptions (page 70)
“If your goal is to be able to trade like the professionals, you must be able to see the
market from an objective perspective, without distortion. You must be able to react
without resistance or hesitation, but with the appropriate amount of positive
restraint to counteract the negative effects of overconfidence or euphoria.”
Chapter 9 The Nature of Beliefs (page 138)
“Our minds are not naturally wired to be ‘objective’ or to stay in the ‘now moment.’ It
means we have to actively train our minds to think from these perspectives.”
Chapter 8 Working with Your Beliefs (page 131)
The Fundamental Truths:
1. Anything can happen.
2. You don't need to know what is going to happen next to make money.
3. There is a random distribution between wins and losses for any given set of
variables that defines an edge.
4. An edge is nothing more than an indication of a higher probability of one thing
happening over another.
5. Every moment in the market is unique.
Practical Personal Investing, Session 6, presented by Greg Shtock
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Practical Personal Investing, Session 6,
presented by Greg Shtock
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