December 21, 2018

Stock Market Rout, Playing the Emotional Game, & Sentiment Feedback Loops

True story:  In the first few days of October 2018 my friend Nate asked me over coffee, “Do you think we’re at the top of the market?”  Over the course of an hour Nate and I went through the market prognosis in detail.  Interest rates were up, housing prices falling, increasing economic uncertainty, and our sentiment indicators were all negative.  We both agreed it was the top.  We closed our conversation with a mutual reminder - “Time to sell everything.”  A few days later the S&P 500 dropped more than 3%, beginning the rout that continues through this week.

But to be clear - I'm no hero.  I didn't sell anything. 

And I’m not alone in my inertia.  Despite what we KNOW to be true intellectually, taking action based on that knowledge is a different beast.

Today’s newsletter examines why it’s difficult for many people to sell at tops and why - based on longer term patterns - the selling may not be over.

IT'S NOT AN INTELLECTUAL GAME

I have various excuses for my inaction in early October - I’m not a market timer, I'm not currently managing money for others, it's not worth my time and attention, etc...  All seemed true at the time, yet all these excuses are intellectualizations. I could have saved a pretty paper penny getting out back then. The leap from armchair investor to professional crosses that motivational chasm.

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October 14, 2018

Sentiment, the "Big One", and Bali

A few months ago my wife and I moved our kids from California to Bali, Indonesia for the year. We've been surprised by the strength and frequency of the recent earthquakes.  During one earthquake I watched waves of water slosh out of our pool.  During another I paused a business call as my roof groaned and light fixtures jangled.  During a few late night earthquakes I’ve been shaken awake in a daze wondering, “Why is my wife jumping on the bed so hard?” Is she doing jumping jacks?!" (She had similarly foggy and illogical thoughts about me).  

We have chosen to live in the “Ring of Fire” where earthquakes and volcanic activity are a fact of life – part of what makes the landscape beautiful, lush, and dramatic.  And despite the instability here, we feel very lucky – residents of the Indonesian islands Lombok and Sulawesi have lost much more than pool water.

Financial markets have their own quakes and tremors, including one this week.  Intellectually, we know such events will happen.  But after each many people wonder “Could this be the Big One?” As a seismologist of the human psyche, in today's newsletter I feel some responsibility to explain what we know about predicting market downturns.  Today’s newsletter explores market quakes: their psychological predictors, the potential this week's tremor was a precursor to the “Big One”, and a Balinese understanding of duality.

Sentiment Momentum

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May 20, 2018

Profiting from Media Outrage

Don't trade angry. Seriously. If you're considering an investing decision and you find yourself feeling angry, stop, walk away, and go do something less destructive, like headbutt your bathroom wall or drop a cast iron skillet on your foot.*
~ Frank Murtha, PhD from The Seven Deadly Sins of Investing: Anger.

The popular TV show "Billions" follows the conflict between powerful U.S. attorney Chuck Rhoades and hedge fund manager Bobby Axelrod.  Chuck's wife Wendy Rhoades is a psychiatrist and the performance coach for Axelrod's hedge fund, Axe Capital.  In the premiere of season 3, Axelrod's professional and personal lives are threatened by rage-fueled misjudgments.  During a coaching session, Rhoades performs an exercise to help him transform his anger.

Axelrod (A) notes that the seeds of his anger were planted when he - a poor kid - was bullied by rich kids: 
A:  "That rage grew in me.  Worked like jet fuel for years." ...
R:  "It was useful."
A:  "Yeah it was, got me here."
R:  "We can agree your rage worked for a time.  I think your brain, instincts, market feel, all that had more to do with it.  But for the moment let's agree that the rage worked for a time.  But let's look for a moment when it was the wrong tool, and it cost you more than it made you.  And about how when you allow your anger to make you blind to consequences it shuts off those more crucial skills." [my bold]

As Dr. Rhoades alluded, anger distorts judgment.  Anger is a unique emotion in that it increases both risk aversion and confidence.  Irate investors are less willing to invest in a socially scorned company, they feel more certain that their decision to avoid them is sound, and they hold on to these risk averse feelings even after the company has taken action to remedy the situation.  As the Buddha noted, "We are not punished for our anger. We are punished by our anger."  Sometimes the anger is projected onto a target, like a company, and we miss opportunities due to our anger-distorted judgment.

In today's newsletter we demonstrate powerful evidence that the stocks of companies described with anger in the media outperform their peers substantially over the following year.  When a company runs afoul of the social consensus - BP due to the Gulf of Mexico oil spill, Facebook due to privacy concerns, VW due to falsifying pollution tests - investors have an opportunity.

The media demonstrates a frequently shifting spotlight of moral outrage.  The phenomenon was captured in this Slate article detailing the daily social and media outrage explosions of 2014.  Such social scorn often lands on publicly traded companies, hitting their stock prices.  Because of the cognitive distortions associated with anger, causing investors to become risk averse, these media pile-ons provide a historically consistent and significant opportunity.

The below equity curve is one of our new quant results from our new Thomson Reuters MarketPsych Indices version 3.0 data set in the talented hands of our Head of Research CJ Liu and Alice Fu. 

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