How Will We Know When to Stop Dancing?
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing."
~ Chuck Price (then CEO of Citigroup) to the Financial Times on July 9, 2007.
According to TD Ameritrade's investor movement index (IMX), individual investor stock purchases broke their all time high in February 2017. Despite large gains already, the U.S. stock market's "Trump rally" may continue, fueled by anticipation of lower tax rates, repatriation of overseas corporate cash, and U.S. fiscal stimulus on infrastructure.
But just as easily as we can cite reasons for the rally to continue, we can find evidence that it's a good time to sell. Some experts (including Nobel laureate Robert Shiller) believe U.S. stocks are overvalued. Rising interest rates may slow the economy. A stronger dollar is hurting U.S. companies' profits. Trump creates a unique level of uncertainty.
It can't be both ways. In this environment of both historically high stock prices and high uncertainty, two prevalent behavioral biases exert their influence over investors. Today's newsletter will explore research reported at last week's neurofinance conference at Lake Lucerne, Switzerland. It then examines how the biases called the Disposition effect (Cutting Winners Short) and the Repurchase distort our thinking in market environments such as this one. Finally, we look for guidance on the stock market going forward.
Neurofinance in Financial Practice
Switzerland-based hedge fund manager Peter Pühringer (German language wiki page) is a generous sponsor of neurological research, including neurofinance. In the markets Pühringer has profited - in part - from a keen understanding of the psychological nature of the interest rate cycle, and Pühringer is now one of the wealthiest men in the region (his personal 70% return last year didn't hurt). He didn't start out wealthy - he was born in East Germany and emigrated to Austria in his early 20s. In his career as an investor, his early successes came from bucking the trend with Saudi real estate development and buying East German real estate in Berlin just after the Wall fell. Last week his firm was one of only two to bid on Ghanian debt during that country's first debt auction.
Pühringer's enthusiasm for market psychology has driven him to become personally engaged with brain research. He renovated the Vitznau Health and Wealth Residence on Lake Lucerne (photo below) which may be the only resort to double as a neurological rehabilitation facility complete with a MRI scanner in the building's basement.
Pühringer's interest in market psychology and economic cycles is evident in the resort's signature statue, depicted below. And on at least one floor, suites at the hotel are named after influential economists and behavioralists including Robert Shiller.
I could write many pages about the fascinating implications of the neurofinance research underway. Given it's relevance to how investors feel after a significant bull market, today's newsletter will examine the neuroscience research of USC finance professor Cary Frydman (see extensive citations below).
"The current level of the CAPE ratio 'would suggest reducing your holdings of stocks, especially for a long-term investor. We can't time the market accurately, but we know that when it's this high, over the long term, it usually doesn't do great.'"
~ Robert Shiller quoted in CNBC, February 24, 2017
In a 28-subject study that combined investment decision making with neuroimaging (fMRI), Frydman found that all participants were susceptible to two common biases - the Disposition effect - in which investors sell their winning investments too soon and hold their losers too long - and the Repurchase effect. The most relevant half of the Disposition effect to today's markets is the tendency to cut winners short. When a stock rises above its purchase price, investors think about their profit as a paper gain which remains at risk of loss. When they fear giving back their profits - as they may do following a slump as we've seen over the past month in the U.S. stock market - they feel inclined to sell and lock-in (realize) the existing gains. As such, we might expect investors to be considering pulling the sell trigger as the U.S. stock market falters.
The Repurchase Effect
According to Frydman, the Repurchase effect is a description of the behavior in which, after investors sell a stock, they are more likely to repurchase shares if the price subsequently falls. However, they are less likely to repurchase shares of a sold-stock if the price subsequently rises. This unwillingness to re-buy the rising stock is a problematic bias because stock prices tend to move with momentum, and high performing stocks tend to keep rising. The losing stocks they repurchase tend to go down more. Investors have an overall lower returns due to this bias. And anyone who sold out of U.S.stocks over the past 8 years must have psychologically struggled to buy into the subsequent rally. The Repurchase effect - in aggregate - may explain stock price momentum. Keep in mind that because of price momentum, investors SHOULD repurchase a stock they sold if it continues up (it will likely go up further).
In his fMRI research, Frydman examined the two brain areas most predictive of financial risk taking - the reward system's Nucleus Accumbens and the loss avoidance system's Anterior Insula. Frydman found that the Nucleus Accumbens deactivates when a sold-stock later goes up. Nucleus Accumbens activation is required to motivate investors to buy a stock in the first place, so its deactivation likely explains why investors do not buy back in - they don't feel motivated enough to do so. This finding is contigent on another interesting finding -- the more excited people feel when they make money in a stock (the more their Nucleus Accumbens lights up), and they sell the stock, then the more likely they will feel regret and not repurchase if it rises further.
In general, Frydman found that investors who are most neurologically activated by stock success and loss are most susceptible to both the Repurchase effect and Cutting Winners Short. These two biases are particularly relevant for investors now that markets have slumped a bit from all-time highs set in February.
In the current bullish market climate investors are torn between locking in their gains (cutting winners short) and, if they are feeling under-invested, chasing stocks higher (or buying on the recent dip).
Stock Price Momentum
In the academic literature, price trends are called momentum, in homage to the tendency of prior months' stock movements to continue into future months, as if driven by physical momentum. Stock price momentum tends to follow prior 2- to 12-month returns. For example, after high price performance over the prior 2 to 12 months, a stock will typically continue to experience such excess performance for the following 6 months. After low price performance, momentum continues in the negative price direction for a similar period.
"Merchant: In this chaos of opinions, which one is the most prudent?
Shareholder: To go in the direction of the waves and not to fight against the currents."
~ Joseph De La Vega. 1688. "Confusion de las Confusiones." (The first book about the operations of a stock market, the Amsterdam Exchange).
The momentum effect yields significant profits for those who take advantage of it. Fed economist Nitish Sinha found that the sentiment tone of news articles predicted whether stock prices would develop momentum over subsequent months. Price underreaction to news tone generated a predictable momentum in prices contributing to a theoretical 8.6 percent excess annual return. Asset management firm AQR frequently publishes research on the momentum effect, and an AQR paper published in the Journal of Finance demonstrates that momentum is ubiquitous, occurring across asset classes including bonds, global equities, currencies, and commodities.
So investors should stay invested now and follow the momentum in individual stocks? Actually, the evidence is complex -- it turns out that momentum only occurs during optimistic market regimes. And there is a trader's saying: “The first bad news is not the last bad news,” an aphorism intended to goad investors into acting
quickly when bad news breaks during an otherwise positive trend. This is important because most momentum investors stay invested too long, under-reacting and holding tight after truly bad news finally arrives to break the trend.
Making Sense of the Research
The key to investing is such times is to understand one's own biases, the psychology of the herd, and understand the triggers that can swing both.
Importantly, long-term investors should not be intently tracking stock prices. Price-following will exacerbate biases such as cutting winners short and the repurchase effect - both of which erode wealth and increase stress. Any thinking that focuses on harvesting winners and keeping losers is analagous to "watering the weeds and cutting the flowers" in your garden. Instead investors should keep track of the company fundamentals and news that may impact those. A focus on the balance sheet and business prospects keeps one's focus where rules can be more reliably applied.
It is also important to retain a layer of emotional detachment from the success or failure of one's ideas. Too much personal involvement also leads to increasingly biased decision making.
Turning our attention to the aggregate stock market, we don't see our sentiment signals flashing danger yet, although conditions can change rapidly.
Housekeeping & Closing
We've delayed our newsletter since January as we finished up our new natural language processing engine. Internally the data tracks every country, city, and region. It covers every currency (including the top 60 cryptocurrencies). It covers fixed income products for every country in the world. And we've expanded our company coverage further. We've also bolstered event and risk-related coverage.
The commercial Thomson Reuters MarketPsych Indices dataset covers 41 currencies, 61 countries' fixed income products, 61 stock indexes, 10,000+ companies and stocks, and 187 countries. We also now deliver two types of sentiment index for each major stock index. And we added several additional sentiment indexes. If you represent an institution, 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.
Richard Peterson and the MarketPsych Team
Here is an excellent summary of Cary Frydman's neurofinance research up to 2012: Dissertation PDF
Journal of Finance paper on Realization Utility: Realization Utility PDF
Reducing the Disposition Effect by not Showing the Purchase Price: PubMed
Neural Regret Signals: Implications
Repurchase effect: Repurchase PDF
Clifford S. Asness, Tobias J. Moskowitz, and Lasse Heje Pedersen, “Value and Momentum Everywhere,” Journal of Finance 68(3) (2013), pp. 929–985.
Joseph De La Vega, 1688, Confusion De Confusiones. Paragraph 67, translated and excerpted from: Corzo, Teresa, Margarita Prat, and Esther Vaquero, “Behavioral Finance in Joseph de la Vega's Confusion de Confusiones,” Journal of Behavioral Finance 15(4) (2014), pp. 341–350.
Nitish Ranjan Sinha, “Underreaction to News in the U.S. Stock Market.” Available at SSRN 1572614 (2010).