MarketPsych Newsletter

MarketPsych Report: The Dynamic of Panic

September 06, 2015

Latest News

September 02, 2015 - We'll be presenting at several events in Budapest, Istanbul, Singapore, and Hong Kong in late September (18-25).  Please let us know if you would like to join us.

Recent Press

August 30, 2015 - A Q&A with Wall Street’s top psychiatrist on market turmoil -- Matthew Craft Associated Press

August 28, 2015 - Why the Market Finally Corrected -- Bob Frick Investing Daily

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.
~ Warren Buffett

Buffett said the above in a New York Times op-ed on October 16, 2008 in the midst of the financial crisis.  The U.S. stock market had already fallen 40% at that time, and numerous banks had failed.  Buffett's forecast was based on excessive fear already in the markets - overreaction.

Following the 10% drop in U.S. equities in August 2015, the financial media was saturated with prognostications of further market declines. Could we be in the midst of a fearful overreaction?  Is it time to buy the dip?

After three years of bullish long-term outlooks, MarketPsych moved to a bearish outlook based on fear creeping into the markets in our July and August newsletters where we predicted "a correction" and a "global rout" (only visible to paid subscribers).  This was later written up in the media.  Our forecast of further declines was based on fear creeping into the markets - underreaction.  

We used fear to predict a price decline.  Buffett uses fear to predict a bounce.  Today's newsletter examines the dynamics of fear in equity markets and when it is better to buy on fear versus when to sell on fear.

Investor Fear

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.  

Fear During a Bear Market

Fear defeats more people than any other one thing in the world. 
~Ralph Waldo Emerson

During a bull market the received wisdom is to buy on dips.  During a bear market such a strategy works in the short term, as prices quickly bounce.  Yet in a bear market prices then roll over and resume the downward move. 

As the financial crisis started, there was surge in fear in February 2007 (when the Chinese stock market fell 10% in one day) and again in August 2007 when quantitative momentum strategies failed and the credit markets froze.  These fear spikes were harbingers of the financial crisis.  Yet each spike also presented a short-term buying opportunity.  An image of fear during the financial crisis is below from January 2007 through March 2009.  The S&P 500 candlestick prices are plotted against a MACD of the Fear TRMI (fear expressed in relation to the 500 constituents of the S&P 500 and the index itself, extracted from both news and social media).  The 30 day average versus the 90 day average of fear are plotted, and when 30-day fear rises above 90 day fear pink shading appears between the lines.  When the 30 day average falls below, then green shading appears.  

The first red spike in March 2007 followed the Chinese stock market sell-off.  The fear rose more dramatically as the quant crisis and credit squeeze began in August 2007.  Buffett's recommendation to buy on fear arrived shortly after the highest peak of fear in the chart.

After fear begins to creep into a market, and prices start to slide into a bear market, periodic bouts of fear still occur.  And each time they appear to represent a panic bottom.  But investors who buy on these dips feel significant pain if they hold longer than 1-2 weeks.

The following image depicts the numerous small price panics that occur during a bear market.  This is from a chart of the Nasdaq 100 from 2000-2002.  The blue line represents the Nasdaq price.  The orange arrows represent the multiple panic lows during the bear market.

From the charts above, based on bear markets, it appears that it is best to buy on fear and hold no longer than for approximately 1-2 weeks.  

Day-to-day Fear Effects

Its not stress that kills us, it is our reaction to it.
~Hans Selye

In the midst of daily trading, it is difficult to step back and gain perspective on how fear is affecting the markets.  On the daily level (and the weekly level) we see evidence that markets tend to overreact to sudden surges in fear, giving credence to Buffett's saying.

Using the Thomson Reuters MarketPsych Indices, our chief data scientist Aleksander Fafula tested the effects of fear about major U.S. stock indexes.  At 3:30 pm New York time (30 minutes before the market's close), when the daily value of fear is greater than one-standard deviation above its 100-day average, then a buy signal is triggered and a long position is entered on the market's close price at 4pm ET.  The long position is held for 24-hours, to the following day's close.  When daily fear is one-standard deviation or more below the 100-day average, then a sell signal is triggered and a short is entered at the close.  This is a simple model that takes advantage of both high fear (buy on fear) and low fear (sell on greed), but it only operates on a daily basis.

Using fear from the combination of news and social media for the Dow Jones Industrials, on 1117 days from 1998 through 2014 the daily fear value was more than one standard deviation from the 100-day fear average.  Taking a position at the following day’s close and holding it through the next day’s close (buying on high fear and shorting on low fear) yielded an average return of 0.10% daily.  A similar strategy on the S&P 500 yields 0.06% daily.  These strategies show a significant effect over more than one thousand days since 1998.  On a daily basis, Buffett's assertion is correct.

When Not to Buy on Fear

Sometimes fear spikes in concert with negative price action.  In those cases fear is a REACTION to the negative price movement.  Such fear may rightly be called "overreaction" as prices generally bounce.  However, in other circumstances fear spikes but prices don't move much, if at all.  There are a few examples in the chart above when fear spiked and then prices fell.  This type of fear, occurring in response to external events, often does filter into prices.  But the carnage often grows worse.  

As can be seen in this Fear MACD 30-90 chart of 2015, Fear has been growing around the S&P 500 for most of the year, culminating in the panicky sell-off of the past weeks.  When the short term 30-day average of fear is above the longer term 90 day average, then pink shading is between the two lines.  When the short term average of fear drops below the longer term average, green shading is present.  The price bars represent the S&P 500.  The chart is from Jan 1, 2015 to the present.

This year fear rose gradually before the August sell-off, then spiked in a short term capitulation which marked a short-term bottom.   This is comparable to the period just before the Lehman collapse in September 2008, when fear was rising dramatically since August 2007.  So in these two cases (and some others), fear rose not in response to price action, but in anticipation of it.  That is the fear that is most dangerous - the fear that prices underreact to.

We only prognosticate on future market direction for Subscribers, and our forecasts are only for entertainment.  Nonetheless, some readers like to see them, and we publish them because of that interest.

Housekeeping and Closing

Think first of the action that is right to take, think later about coping with one's fears.
~Barbara Deming

On the one hand, spikes in fear usually generate short term buy signals.  Longer-term, as Buffett indicated, a dramatic spike in fear in the midst of a bear market may be capitulation, and prices will generally be higher after the following 12 months.

On the other hand, following a long period of positive price trend, a spike in fear often heralds a bear market.  Fear that spikes but is not accompanied by negative price action is the most dangerous.  The negative price move will typically follow.  

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.

Stay Calm and Carry On,
The MarketPsych Team
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