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Written by MarketPsych CEO Dr Richard Peterson, our free newsletter provides commentary on current events from a behavioral perspective. Additional topics include behavioral theories and our latest research results.

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November 01, 2015

Becoming a Superforecaster, Gold, and Feedback Effects

Most of the empirical research in finance, whether published in academic journals or put into production as an active trading strategy by an investment manager, is likely false.
~  Campbell Harvey and Yan Liu, “Evaluating Trading Strategies,” 2014. 

Having access to more information, more quickly, is fundamental to optimal forecasting.  Yet we are overwhelmed with such information.  IBM estimates that global data volume doubles every 18 months.  For example, as of 2013, over 100 billion business emails were sent daily.   If computers could autonomously make sense of this data deluge, then the volume would not be problematic.  But computers do not understand meaning, and they need human assistance to develop better forecasts from the data.  

For the humans who create forecasting models on this data, making predictions is an exercise fraught with risk.  The potential problems range across humans biases to data errors to inappropriate application of statistical tools.  Perhaps the most common problem is overfitting - a problem made worse by the availability of increasingly complex statistical tools.  MIT professor Andrew Lo summed up the problem of statistical overfitting neatly with this statement, "I’ve often said that, you know, whatever back test you’d like to see, I can certainly produce it for you. If you torture the data long enough, it will basically tell you anything you want."

Given the expertise needed to find predictive meaning in the massive volume of global information, and the predictably poor models and forecasts of experts, Phillip Tetlock set out to identify the traits of what he calls Superforecasters - people who are excellent at synthesizing information and making predictions of the future.

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October 04, 2015

When Markets and Minds are Inside Out

All right! We did not die today, I call that an unqualified success.
~Fear, Inside Out (Disney, 2015)

On a long flight somewhere over Asia last week I watched the new Disney-Pixar movie "Inside Out."  As usual for a Pixar film, the movie is a brilliant piece of entertainment.  What surprised me was that it is also a path-breaking exploration into the nature of the unconscious mind.  Perhaps amazingly, this children's movie contains lessons for investors, and those are the topic of today's newsletter.

Inside Out is set in the mind of a girl named Riley from Minnesota.  We see the interactions of five manifestations of her emotions — Joy (yellow in the image below), Sadness (blue), Disgust (green), Fear (purple) and Anger (red). The emotions influence Riley's experiences, behavior, and memories via a control console. Joy acts as the dominant emotion to keep Riley in a happy state, but when Riley is 11 years old, her family relocates to San Francisco.  Riley has trouble at her new school, and Joy loses control of Riley's experiences.  The premise of the movie - that emotions drive most of our behavior - is supported by modern research.  Despite this seemingly esoteric topic, the movie is very popular, having grossed over $774.5 million worldwide as of September 27th. 

Just as Riley's life was moving along happily until the shock of her move to San Francisco, market prices usually plod along in fairly rational ways - happily on autopilot - until a crisis occurs.  While on autopilot, markets are susceptible to underreacting to negative information, giving emotionally-saavy investors an opportunity to act before others understand what is happening.  During a crisis, anger or fear dominate investors' collective behavior, creating patterns that investors can identify and take advantage of.  Today's newsletter examines how both happily "rational" periods and those of crisis exhibit price patterns.  The letter also addresses how investors can maintain optimal emotional function and adapt to changes in the dominant market emotions.

# What Moves Crude?

In "Inside Out" the Train of Thought - is depicted racing through the mind while linking memories, plans, and feelings.  The train of thought represents one's conscious experience of the world, and it is the foundation of analytical thought.  While emotions always color thought, the use of analytical reasoning about these emotions allows one to gain useful perspective.  Using our Thomson Reuters MarketPsych Indices, we can analytically examine the effects of emotions - and loaded topics - on prices.  We have begun to identify the predictable aspects of both happily rational and negatively emotional markets.

In 2013 we developed a crude oil forecasting strategy using moving average crossovers (MACDs) of a specific type of sentiment index called PriceDirection.  As a quick aside, sentiment is difficult to detect for assets like crude oil, in which media commentary may reflect the sentiment of either producers or consumers, whose feelings are diametrically opposed whether prices rise or fall.  As a result, we find that discussions of the price action itself is a more useful sentiment indicator for crude oil.  For example, when prices are widely discussed to be rising, momentum tends to set in, and they do subsequently rise.  We developed a sentiment-style index called the "PriceDirection" index to capture this phenomenon.

Given the sentence, "Crude prices rose today," the PriceDirection Index would receive a positive score (PriceUp = 1) from that sentence.  However, if the text analysis engine analyzes this text string: "News of oversupply drove oil prices lower in late trading," the PriceDirection index would receive a negative score (PriceDown = 1).  If both sentences occur in the same hour and no other such commentary is received, then the PriceDirection index would be zero value (PriceDirection = PriceUp - PriceDown = 1 - 1 = 0). 

Using both short-term and long-term moving averages of the PriceDirection index, our Chief Data Scientist Aleksander Fafula found that when short term discussion leans towards prices falling, they subsequently tend to fall.  When short term conversation about prices rising dominates, they tend to rise.  This is a recent image, and depictions of this strategy back to 1998 show significant value.  In recent years the overall strategy yields a more than 25% average annualized return with a Sharpe ratio > 1, as described in this prior newsletter.

The PriceDirection index does a good job of predicting price trends when there are no dramatic or rare events affecting the oil markets.  Joy and pleasant feelings create a trend that carries forward.  Good feelings beget good feelings, and vice versa.  However, when a militia threatens to blow up an oil pipeline, we see a sharp rise in emotions such as fear.  And as fear comes to dominate perceptions, prices overreact.

The best statistical tool to capture the effects of high emotion levels on price behavior is a decision tree.  Decision trees examine the effects of extreme levels of one sentiment versus the subsequent price action in the asset. When the fear TRMI is increasing from week to week (rising emotions), at the most extreme level we see 19 samples with a large jump in weekly fear, and these are followed by an average weekly price increase of 3.2% over the subsequent week for crude oil.

However, fear-based mispricings do not remain in market prices for long.  When fear is high for one month, crude oil prices subsequently fall.  Using monthly averages, in the 19 months since 1998 with the highest fear (top decile), the following month had an average price decline of -5.4% for crude oil, and prices declined in 100% of subsequent months.

When crude oil fear is neither high nor is changing dramatically, then the crude oil price tends to trend, and the PriceDirection indicator is the best predictor of the price at those times of trending.  Overall, using PriceDirection alone is a viable strategy, since rare events are, by definition, rare.

# How Feelings Sway the S&P 500

While crude oil is largely trending on autopilot punctuated by periods of fear, the stock market responds to a diverse range of emotional provocations.  All together, the emotional tone of information is summarized as sentiment.  As sentiment in the media turns, prices tend to follow.

The following chart of sentiment is similar to that of crude oil, but longer averages were used to improve readability since the chart is a longer duration (back to 1998).  This simple strategy returns more than double the S&P 500 by going either long or short based on the prevailing sentiment balance about the S&P 500 (it turned negative this year, contributing to our bearish forecast on the S&P 500 in July 2015).  This strategy would have held short through the financial crisis and the dot-com collapse.

Aleksander Fafula found that fear is mildly predictive of next-day reversals in the S&P 500.  On a daily basis, short term fear is an overreaction for the S&P 500, as it is on a monthly (and daily) basis for crude oil.

# Managing Your Train of Thought

Crying helps me slow down and obsess over the weight of life's problems.
~ Sadness, Inside Out (Disney)

Crowd behavior (a.k.a. herding) occurs when events exert a strong pull on investors.  Investors can use the power of conscious thought to reframe events and replace such compelling feelings, thus avoiding the underreaction or overreaction of the herd.

Personality traits represent ingrained emotional habits, and they color one's thinking about the world.  Over 28,000 people have taken our free online financial tests since 2004, and the Investment Personality Test is the most popular test.  The personality tests measure the Big 5 personality traits:  Extraversion vs Introversion, Agreeableness vs Self-interest, Neuroticism vs Emotional Stability, Openness to New Experiences vs Traditionalism, and Conscientiousness vs Spontanaeity.  The Big 5 personality traits are not strongly correlated with overall investing performance (several sub-traits are more interesting), but given our large sample size, we are able see a statistically significant correlation between long-term investing success and two traits:  Emotional Stability and Openness to New Experiences (Openness). 

If you find yourself low on Emotional Stability, consider whether this is a bad thing.  Many people find the full experience of emotions useful, as it helps them to be more sensitive to their environment.  At the same time, when emotions become extreme for a long period, poor decision making may result.  For investors it is useful to avoid situations that will provoke damaging emotions.   Preventive stress management - healthy routines and rhythms to your day - can minimize the likelihood overwhelm.

The second identified performance trait - Openness  - is strongly correlated with mental flexibility and adaptability, and it is a trait of top investors such as George Soros (e.g., his Open Society Institute). 

As Riley does in the movie "Inside Out," redirecting one's train of thought (cognitive reframing) allows one to dwell on topics or memories that create a productive state of mind.  At the same time, as Riley experiences in the movie, one ought not to use cognitive reframing to avoid nagging problems, as they will only grow worse if continually reframed without relieving the emotional core of the issue.

# Housekeeping and Closing

Joy: Come on, group hug! You too, Anger.
Anger: Don't touch me.
~ Inside Out (Disney)

As go the forces that drive Riley's behavior in Inside Out, market prices are either 1) floating along quietly, driven by reasonable expectations while underreacting to new information or 2) dramatic, emotional, and characterized by overreaction.  We see predictability in both contexts, but while using very different TRMI indexes.  Broad feelings drive markets during #1, while negative emotions like fear are the best predictors during #2.

We love to chat with our readers about their experience with psychology in the markets.  Please send us feedback on what you'd like to hear more about in this area.

Please contact us if you'd like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor real-time market psychology and macroeconomic trends for 30 currencies, 50 commodities, 130 countries, 50 equity sectors and indexes, and 8,000 global equities extracted in real-time from millions of social and news media articles daily back to 1998.

Celebrating all of our investing emotions,
The MarketPsych Team

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September 06, 2015

The Dynamic of Panic

No passion so effectually robs the mind of all its powers of acting and reasoning as fear.
~Edmund Burke

Humans are predisposed to fearful overreaction.  Research on individual propensity to fear and the serotonin transporter gene was featured in a prior newsletter.  It is not only static factors like genes that affect risk tolerance.  Changes in stress hormone levels - specifically chronic increases in cortisol - also change the risk tolerance of investors.  

In a paper in the Proceedings of the National Academy of Sciences, "Cortisol Shifts Financial Risk Preferences," researchers find that humans are more concerned about risk after being subjected to sustained stress:  "Specifically, the stress response calibrates risk taking to our circumstances, reducing it in times of prolonged uncertainty, such as a financial crisis. Physiology-induced shifts in risk preferences may thus be an underappreciated cause of market instability."

Chronic increases in stress hormones lead to cognitive shifts such as probability neglect, in which a small probability of a catastrophe becomes overweighted in the decision making process.  As fear increases and prices fall, a positive feedback loop occurs in which 1) attention is riveted onto short-term news and information flow and 2) media chatter about the crisis escalates.  These two factors amplify each other, raising stress hormones and decreasing investor risk tolerance.  A selling climax, in which the price action crescendos into a sharp panic, results.  The peak of the panic is a price capitulation in which investors are collectively selling in fear.  

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August 09, 2015

Innovation, Vision, and Stock Prices

I cannot help fearing that men may reach a point where they look on every new theory as a danger, every innovation as a toilsome trouble, every social advance as a first step toward revolution, and that they may absolutely refuse to move at all.
~ Alexis de Tocqueville (1840)

The past 10-15 years has seen an explosion in innovations: self-driving vehicles (Google), all-electric vehicles (Tesla), inexpensive space launches (SpaceX), the sharing economy (Uber and AirBnB), genetic technologies and cancer immunotherapy, online education (often free), drones, smart phones (Apple, etc...), 3-D printing, robotics, maker spaces, the internet of things, and machine learning - which is itself opening up entire new fields including robotics and translation - let me catch my breath here.  Regardless of these amazing innovations over the past decade, some experts believe that these are simply enhancements, not game-changing innovations.  They debate whether the economy has reached a plateau of innovation.

Tyler Cowen, a professor of Economics at George Mason University and author of the MarginalRevolution blog, authored "The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better," a pamphlet published in 2011. His work argues that the American economy has reached a technological plateau and the factors which drove economic growth for most of America's history are spent. The "low-hanging fruit" from the title include the cultivation of previously untilled land, the spread of transport, refrigeration, electricity, mass communications, and sanitation innovations from 1880-1940, mass education, and potentially cheap fossil fuels and the strength of the American constitution. While those produced extremely large returns, future advances will be much more incremental. In a vivid example, he compares the changes witnessed by his grandmother versus those over his own lifetime, and finds the changes he has witnessed to be incremental rather than world-changing.

Cowen takes a critical and too-narrow view of some recent innovations.  He noted on his blog about the hyperloop, a technology to transport people through pneumatic tube-like systems at around 500mph:  "I cannot speak to the technical issues ... but I wonder where the real gain is....  You can already fly LA to San Francisco in about an hour.  Is saving that time so important, noting that in the best case scenario the hyperloop still takes 35 minutes?"

Cowen's argument neglects that one of the most important aspects of inventiveness and innovation - the DREAM.  People - employees, investors, regulators - are motivated by vision.  If we deconstruct the vision into its parts - what is feasible with current technology and what is not - we will never try.  And even when a new project fails, it often leads to new spin-off technologies and greater wisdom about what works and what doesn't.  Steve Jobs understood this, and so does Musk - as he demonstrates when he requires nay-saying employees to explain the materials chemistry and physics that prevent an idea from being manifested in technology.   Once the physics makes an idea in the realm of possibility, then the emotional inspiration of the vision is the motivation behind its ultimate achievement.

Ashlee Vance notes that Musk has two posters of Mars outside his office at SpaceX.  One is Mars now - red rocks and dust - and one depicts Mars transformed into a viable environment for human life - blue and green and with an atmosphere.  That VISION is tangible and emotionally resonant.  It is a guiding inspiration for his commercial ventures.

We are on the verge - within the next 30 years - of living in a world of Mars colonies, cancer cures, free online education, travel by hyperloop, a world of self-driving vehicles and drones.  Regardless of naysayers, the visions that succeed over the next decades will be those that inspire.  Many innovations are possible but have simply not been dreamed of.  Those that are brought to life will be those that inspire smart people to dedicate their lives.

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July 12, 2015

Risk-on? How fear triggers sell-offs and when to catch the falling knife

Investing is an activity of forecasting the yield over the life of the asset; speculation is the activity of forecasting the psychology of the market.
~ John Maynard Keynes

On the morning of May 6, 2010, mayhem erupted on the streets of Athens, Greece.  Later that day, the Flash Crash occurred, sending the U.S. stocks markets down by 9% intraday.  A random coincidence?  The data suggests not.

Like that May day in 2010, the spectre of default risk raised its head this month.  Chinese equities plummeted, Grexit appeared imminent, and even little Puerto Rico contributed a scare.   Institutions have a limited power to save us from ourselves, as this excellent article by Jason Zweig recounts, and investors were again reminded that the surges of emotion through markets - especially fear- can drive prices dramatically.  A global risk-off movement took hold briefly, and given the disquiet produced by events in China and Europe, it is probable that the volatility is only beginning.  

Risk-on behavior is a collective pursuit of financial safety, while risk-off describes the flow of capital to momentum-driven and higher yielding securities.  Periods of risk-off are catalyzed by a growing sense of unpredictability, increasingly negative news flow, and rapidly falling prices.

Today's newsletter looks at how a seed of doubt, once germinated, can begin to choke investors with tendrils of fear.  We examine a sentiment-based sell signal in China before the recent downturn which is similar to a signal seen before the May 2010 Flash Crash.  The question for investors on the sidelines of such panics is when to "catch the falling knife" and buy into the fear.  Evidence shows that Warren Buffett is correct to counsel us to "buy on fear," but ONLY when fundamental valuations are also attractive, which we demonstrate through recent research.

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