Intuition, AAPL, and Tuning in to the Market's Rhythm

LATEST PRESS

Top Financial Institutions are Regaining Trust News and Social Media Analytics Show. Quartz.

Trader's Tap Twitter for Top Stock Tweets. Oct 11, 2013. James Macintosh. Financial Times.

Curtain Could Fall on Social Media ETF Party" Oct 8, 2013. Trang Ho. Investor's Business Daily.

UPCOMING EVENTS

See us in San Francisco on November 9, 2013 and Orlando November 17, 2013.

INTUITIVE INVESTING

What is it the good managers have? It's a kind of locked in concentration, an intuition, a feel, nothing that can be schooled. The first thing you have to know is yourself.
~ Edward Johnson, Founder of Fidelity Investments

In the quote above Johnson was not entirely correct about one thing. Bad investment managers do not have "locked in concentration, an intuition, a feel" due to the fact that they cannot be learned in school (e.g., in business classes, trainings, etc.). They can be learned, but the problem is that these characteristics have not been properly taught. Although self-knowledge cannot be memorized from a book, skills for developing self-knowledge can be learned.

The goal of today's newsletter is shed some light on the nature of investing intuition.

Feel for the market, trader's intuition, gut instinct, and acting from the zone refer to those times when our investing flows naturally, as if in tune with the market's rhythm. Our thinking is clear. Our reactions to market events are correct. Trading decisions are seamless.

While I'm an empiricist by temperament, intuition is notoriously difficult to study in the context of decision making. We often know when we have an intuitive insight, but when we try to define it specifically, it's an evasive concept. The circularity of intuitive feelings is parodied in this Dilbert comic strip and this one.

Famous intuitives include George Soros and Jack Welch (his 2000 book was titled: "Jack: Straight from the Gut"). Infamous intuitives include Alan Greenspan, who asserted in his 2007 book The Age of Turbulence, "To this day the bathtub is where I get many of my best ideas." Intuitive insights often arrive when we are relaxed, thinking about something completely different from the markets, or perhaps nothing at all. It is in these quiet moments that the collected inputs of the past days and weeks coalesce in our brains, patterns and relationships are recognized, and insights bubble up into our awareness.

DAMASIO'S GAMBLE

The ability to tap into "gut feelings" or what we call intuition is not only a weapon in our investing arsenal, it's the hallmark of some of the world's greatest investors. A study in the early 1990s by neurologist Antonio Damasio, then at the University of Iowa, demonstrates this point well. Damasio took an interest in several patients with unique lesions in his neurology clinics. His patient group had lesions of an area of the brain called the ventromedial prefrontal cortex. These lesion patients retained their basic intelligence, memory, and capabilities for analytical reasoning and for logical thought, but they made poor decisions in risky situations.

Damasio wanted an instrument to detect his patients' problem with risk processing, but no formal tool was available. He designed a card-playing game called the Iowa Gambling Task to measure the responses to risk in these patients. The patients were connected to electrophysiological arousal monitoring devices (as in lie-detector tests) such as a skin conductance response (SCR) monitor. In Damasio's task, four decks of cards were laid out. The subjects then selected cards from any of the four decks of cards with the overall goal of maximizing their financial gain.

Subjects were not told the overall odds or payoffs of the card decks. They were simply told to play the game and to try to make as much money as possible. The two decks on the left, "A" and "B," yielded either cards valued at $100 or -$1,250. The two decks on the right yielded cards valued at either $50 or -$250. The expected value of each card in decks A and B was -$250, while for decks C and D it was $250.

Normal subjects learned to avoid the losing decks. After flipping the first 10 cards, they began to show physiological stress reactions on the SCR measurements when hovering over decks A or B. Although the normal subjects experienced a physiological stress reaction after 10 card flips, they could not confirm a hunch that decks A and B were the money-losing decks until over 50 card flips later. They had physical stress reactions to the losing decks after 10 flips and gradually changed their behavior to prefer decks C and D. Yet they only articulated a hunch about which were the losing decks after 50 card flips. They could explain their hunch with certainty only after 80 flips.

Damasio's research implies that people need subtle feelings to signal when to avoid losses in risky environments. When making risky decisions, there is a gap between what the emotional brain (the limbic system) knows about risk and one's conscious awareness of the actual danger. Intuitive decisions, where "gut feel" drives judgment, arise from recognition of such limbic knowledge.

As investors, we want to shorten the time lag between when our body recognizes danger (after 10 card flips) and the moment we become consciously certain of the danger (after 80 cards flips). For example, George Soros was reported by his son to become aware of danger in his portfolio because he begins experiencing lower back pain. His physical pain is a cue that brings the hidden danger into awareness.

TYPES OF INTUITION

If you can't imagine it, you'll never see it coming.
~ Anonymous fund manager

Even though "market feel" is an emotional concept, it lies underneath the day-to-day emotions most people feel when trading. Anxious investors are not experiencing a nervous intuition, they are feely panicky. Hopeful investors are feeling hope. Exuberant investors feel euphoric. Intuitive feelings are more subtle than these. Intuitions feel like an alignment, a click into place, a shift into the best mental position. Intuitions relieve tension, they don't add to it. When contemplating a, an intuition feels like a subtle clarity, a shift, an "ah-ha" in the mind that leads to a sense of certainty and the thought: "That's going to happen."

Investors typically have one of two types of intuition. When they are invested, they may experience an intuition of danger. Danger intuitions are felt in our bodies (George Soros' back pain) or manifested in our behavior (fitful sleep) before we are consciously aware. When we have an insight about an opportunity, we're more likely to think "that's it" and feel an easing of tension.

There are some obvious potential problems with this two-fold division. Some people are chronically nervous, and every down tick in an investment feels like a crisis. Intuitions of danger are only useful if they arise from a place of mental equanimity. That is, an intuition of danger does not feel scary. It feels factual, like a pain in the gut and recognition of an objective danger. Sometimes we recognize that an intuition means we are positioned incorrectly, and then anxiety arises. In that case, anxiety is a reaction to the intuition. Other times we feel butterflies in the stomach. Butterflies signal arousal and are not an intuition of danger.

Think about and write down your own physical cues of an intuition.

OVERTHINKING INTUITION

Imagination is everything. It is the preview of life's coming attractions.
~ Albert Einstein

When I was in college, a friend of mine lost control of his motorcycle on a sharp bend in the road. He was going fast, as he had done many times before on this corner. Fortunately he was relatively unharmed. Knowing that he was technically an excellent rider, I asked him, "What happened that caused you to go down?" He answered, "I started thinking."

When we start driving a car, we drive slowly and think carefully at every turn. As we gain mastery of driving, the basic behaviors become automatic and flow smoothly. It's not only true of motor behavior - trading with the rhythm of the market becomes automatic and intuitive as well. What ruins the efficiency of this automatic behavior is when we start thinking in the middle of execution.

A colleague of mine kept a detailed trading journal for more than three years when he first started trading. Each day after the equity market close he jotted down his intuitive sense of whether the market would rise or fall over the next day, week, and month, his level of confidence in his forecasts, his state of mind, and a few other other details. At the end of the three-plus years he had over 850 days of data.

After the first four months of using the trading journal, he noticed that his intuitive feel was a reasonable predictor of prices, with 70% weekly accuracy over those 4 months. As a result, he started merging his intuitive feel with systematic trading strategies he had already been using and trading. And the results were startling.

But not in a good way.

Over the course of 850 days of self-collected data, his weekly predictive accuracy averaged 70% on days when he had no bets in the markets and dropped to 30% accurate when he had money on the line. Taking a bet on his intuitive sense ruined his feel for the market. He started overthinking when he had something at stake. He placed too much importance on each and every trade, because he believed that needed to make money. When he pressured himself to get it right, he was wrong. When he didn't worry about outcomes, he was more often right.

Overthinking, pressure, and worry are the most common saboteurs of your intuition. The key is to resisting these saboteurs is to remain alert, focused, balanced, and detached from outcomes in the midst of your trading day. If it sounds like Zen, well that's because meditation is one useful tool for unlocking intuition.

LOSING YOUR MARKET FEEL

Intuition is a sensation that if you aren't focused - if you're multitasking all day - you'll never feel it.
~ Anonymous Fund Manager

It doesn't take much to be knocked out of rhythm with the markets. A few small losses, time pressure to achieve a performance benchmark, unusual price patterns - all can lead to overthinking, trading hard to make back the losses, and a feeling that we're out of tune.

When we're feeling out of tune with the market, our natural urge is to get more information. But be careful. One often overlooked cause of intuition impairment is excessive information. If you find yourself unable to feel the market's rhythm, step back and assess how many data points are you relying on. And ask yourself, "what does this market care about right now?" Then pare down the data you are following to the essential three or four.

In my experience, the best traders see losses as an opportunity to relax, not to work harder. They take smaller position sizes and watch them carefully to get back in tune with the market. Gradually they reestablish their equilibrium.

There is a tendency to use half-assed reasoning that can't be logically justified and call it intuition. That is of course intellectually dishonest, and is a sign of a much bigger problem than we can explore in this letter.

MARKETPSYCH DATA TOOLS FOR BOOSTING INTUITION

Intuitions arise as our brains process and find connections in the wealth of information available to investors. We find that our own data allows us to more rapidly identify news and social media information that moves an asset prices. Our goal is accelerate the process of intuition by analyzing which threads of information have been price drivers historically, and assessing how the current information flow compares. To that end Changjie Liu set up Classification Trees to identify the specific price drivers (sentiments and topics recently in news and social media) that correlate with price action over the following period.

For example, take a look at the image of two classification trees below. We can see that Delays (as seen in lower-than-average values of our Urgency variable) and Uncertainty are most predictive of Boeing's share price over weeks. In weekly periods over the past 78 weeks, when conversations about Delays are high (55% of the weeks), Boeing stock goes up 77% of the following weeks (see the top figure, left branch, in the image below). On the right branch, when Urgency is high, and Volatility is low in conversations, the stock drops the following week 94%(!) of the weeks, accounting for 23% of the sample. This is a very contrarian result that reinforces the intuition that investors overreact to news. Also interesting with Boeing is seeing exactly the memes that have been driving the stock price. On a monthly basis over the past 6 years, when Uncertainty surrounding Boeing rises into its top decile (top 14% of the sampled months), Boeing stock slumps 100% of the following months. In summary, over weekly periods Boeing stock has been driven - in a contrarian fashion - by news about delays and changes at the company (volatility). On a monthly basis, Boeing stock is primarily driven by Uncertainty.

Each asset is driven by different threads of information at different times. As we accurately predicted in our newsletter 2 months ago, Violence (war) is an inverse predictor of oil prices when tensions are high. And as we reported in this newsletter projections of price direction are inversely predictive of many asset prices.

We also find that broad themes emerge in our data around stock price drivers. For example, Apple (AAPL) is a stock that has been much loved (and despised) over the past few years.

SHORTING APPLE

The main thing I've learned is intuition.
~ Steve Jobs, after returning home from a youthful trip to India

At MarketPsych our resident quant geniuses - Changjie Liu and Aleksander Fafula - developed tools to identify whether specific sentiments, economic themes, or price action are driving security prices. For Apple stock (AAPL), Aleksander found that over the past three years the stock has largely been driven by Joy. When Joy is rising, the stock rises, when Joy falls, the stock price tends to follow. See the chart below, where the price is the candlestick bars. When short-term Joy about AAPL rises above long-term Joy, there is greed shading, when it falls below, there is pink shading. The colors correlate reasonably well with the price action:

A fund manager friend of mine recently recounted the story of when he shorted Apple at $700. "I was at the gym one day and two portfolio managers - in separate conversations - enthusiastically whispered to me ‘Apple is going to $1,000 a share, it's a sure thing!' I got this feeling that I HAD to short Apple as soon as possible." While my friend intellectually knew Apple was valued cheaply, remained fast-growing, and was in a powerful upwards price trend, the enthusiasm of his fellow fund managers triggered an intense feeling that something bad would befall AAPL.

Fortunately, investors don't have to poll the members of their gyms to find overvalued stocks, as you can see above, the consensus is being quantified in social and news media. For you personally, there are a number of exercises available to help you tap your intuition. Try a few or all of these to see which fit you best.

BEHAVIORAL TOOLBOX: TECHNIQUES FOR ACCESSING YOUR INTUITION

The earth has music for those who listen.
~ George Santayana

In a hyper-connected world, the challenge to accessing intuition is creating mental space and quiet. Once that quiet time has been defined or scheduled, then as your brain identifies subtle patterns in data, insights will have a time to bubble up into awareness. In the following lines we suggest a number of simple exercises that have been shown to enhance intutive or creative thinking. Meditation is an excellent tool for willfully quieting the mind. In fact, Rupert Murdoch recently tweeted: "Trying to learn transcendental meditation. Everyone recommends, not that easy to get started, but said to improve everything!"

Do a Meditation. The following is a mindfulness style meditation. Close your eyes, and with your eyes closed, say to yourself (and feel) the following phrases. On the in-breath identify, and on the outbreath let it go.

1. Breathing in: "I know my mind,"
2. Breathing out: "I am not my mind."
3. Breathing in: "I know my thoughts,"
4. Breathing out: "I am not my thoughts."
5. Breathing in: "I know my emotions,"
6. Breathing out: "I am not my emotions."
7. Breathing in: "I know my witness,"
8. Breathing out: "I am not my witness."

Your witness is also called your "observer" - it's the little you who is constantly watching and observing what you are doing and thinking. When you let it go on the out-breath, you may notice an involuntary sigh, indicating that you've let go of tension. Now your mind will be clearer for a moment. Repeating this a few times opens up mental space for intuitions to emerge. This exercise was adapted from Thich Nat Hahn.

Ask the Market. Each morning, rather than asking yourself, "What should I do in the market today?" Instead reframe the question as, "What is the market telling me to do today?"

Brainstorm for Insights. Sometimes we're paralyzed in our decision making. Have you ever flipped a coin to help you make a decision, and when the coin landed on one option, you immediately realized you wanted the other? Try the following exercise to help you understand your gut inclination:

1. Think about an investment or potential investment you are currently struggling with.
2. Sit down at a desk with three blank index cards.
3. Write three possible actions (or inaction) you could take with it, one on each card.
4. Turn the cards blank-side-up, shuffle them around so they are anonymous, and place them face-down on a table.
5. Hover your hand over each card and assign a percentage to it based on how powerfully you're drawn to that course of action (but remember, you can't see the action).
6. Turn the cards over and take note of your card with the highest percentage. Does that feel right or wrong? Which one feels like it should have been highest rated?

Perform a Sacrifice. In many religious traditions money is given to the temple, or burnt, in sacrifice. We give up something we desire - we burn it in the flames of consciousness - in order to show, both to our self and to the markets, our willingness to follow something other than our own ego. We sacrifice the small for the great, the outward for the inner, worldly things for purity of consciousness. Only by giving up our pursuit of worldly desires - the financial outcomes - can we have the mental quiet needed to hear the market's whispers. In sacrifice we surrender our ideas of comfort, our ideas of our self, and our preconceptions of the market. In return we are given access to the Truth of now.

Do a Handstand. Only do this if you're athletic or with doctor's approval. Propping yourself up against a wall in a handstand will reset your thinking. Could be the exercise, could be the inversion of your perceptions. In any case, it helps to break patterns. I've got clients who swear by it.

Take a Walk in Nature. Studies show that creative problem solving - the integration of multiple inputs - occurs more rapidly after a walk in a natural environment. It is theorized that the complexity of nature, the subtle sounds and sensations, drive our minds away from chewing on the obvious and into a more nuanced awareness.

Ask Good Questions. "What else could I possibly imagine happening?" "What if I didn't do anything right now, what am I afraid of?"

Calm Your Mind. Take a Warm Bath, Hot Shower, or Other Calming Sensory Experience.

Housekeeping and Closing

We’ve got a busy Fall 2013 with speaking engagements in Toronto, Orlando, San Francisco, Berlin, and Warsaw. We look forward to reconnecting with our friends in those cities! Please contact Derek Sweeney to book us for a talk or training at one of your events:
[email protected], +1-866-727-7555.

Please contact us if you’d like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor market psychology and macroeconomic trends for 30 currencies, 50 commodities, 140 countries, 40 equity sectors and industries, and 6,000 U.S. and global equities extracted in real-time from millions of social and news media articles every day.  Here’s a video by researchers at the Stevens Institute of Technology and Thomson Reuters R&D discussing how our data is helping to solve the “Forward Premium Puzzle” in currencies, answering the question, “why does the carry trade work?”.

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

Happy Investing!
Richard L. Peterson, M.D. and the MarketPsych Team

REFERENCES

• Damasio, A. 1999. The Feeling of What Happens: Body and Emotion in the Making of Consciousness . New York: Harcourt Brace.
• Bechara, A., A.R. Damasio, H. Damasio, and S.W. Anderson. 1994. "Insensitivity to Future Consequences Following Damage to Human Prefrontal Cortex. " Cognition 50: 7 - 15.
• Bechara, A., H. Damasio, D. Tranel, and A.R. Damasio. 2005. " The Iowa Gambling Task and the Somatic Marker Hypothesis: Some Questions and Answers. " Trends in Cognitive Sciences 9(4) (April).
• Bechara, A., H. Damasio, D. Tranel, and A.R. Damasio. 1997. " Deciding Advantageously before Knowing the Advantageous Strategy. " Science 275: 1293 - 1295.