In his book "Sapiens" Yuval Hariri explains the evolutionary logic that governed the rise of humans. One of the key themes of the book is that all large-scale human cooperation is based on the stories we tell each other. These stories are narratives that unite us in belief and motivate us to achieve goals. No other animal can rally millions of its members to serve an abstract idea.
Almost 99 percent you realize is just stories in our minds. This is also true of history. Most people, they just get overwhelmed by the religious stories, by the nationalist stories, by the economic stories of the day, and they take these stories to be the reality.
~ Yuval Hariri, Historian and author of the books "Sapiens" and "Homo Deus"
In financial markets stories drives the rise and fall of interest rates, housing prices, currencies, and the stock market. When a single story rises to dominance, a price trend may develop and gain momentum. When such stories become detached from fundamental reality, they often implode in a spectacular fashion -- first racing higher in a manic bubble and then plunging in panic.
Sometimes such stories become mired in confusion and uncertainty. The withdrawal of the UK from the - supposedly inevitable - European Union, or the election of Donald Trump despite the widely predicted victory of Hilary Clinton, are examples. The resulting chaos creates a vacuum in which new stories and narratives take seed.
Today's newsletter examines the power of stories, the role of uncertainty at turning points, and how stories underlie the sentiment cycles in market prices. An updated sentiment chart of the S&P 500 is below.
The Story of Money
To understand how a piece of paper (or computer code) can hold value as currency, it helps to look at the power of belief. One of the most remarkable demonstrations of the power of belief is the placebo effect.
Money is probably the most successful story ever told. It has no objective value. It's not like a banana or a coconut. If you take a dollar bill and look at it, you can't eat it. You can't drink it. You can't wear it. It's absolutely worthless. We think it's worth something because we believe a story. We have these master storytellers of our society, our shamans — they are the bankers and the financiers and the chairperson of the Federal Reserve, and they come to us with this amazing story that, "You see this green piece of paper? We tell you that it is worth one banana."
~ Yuval Hariri
The placebo effect describes the objective benefits of an event or chemical substance (e.g., a sugar pill) that occurs entirely due to a person's belief in the efficacy of that treatment. The placebo effect is an integral part of establishing whether a novel medication heals an illness better than chance, via the double-blind placebo-controlled trial.
The placebo effect accounts for more than 50% of the benefit of most medication treatments of mood disorders and pain (and 100% of the benefit of some common surgical treatments). In general, "panic disorder is highly responsive to placebo, with a nearly 50% improvement in symptoms among patients assigned to that treatment strategy. In patients with posttraumatic stress disorder or depression, the placebo response is greater than 30%, and a response in the 30% range is also seen in generalized anxiety disorder."
The science writer Erik Vance wrote an entertaining book on the power of placebo. In an article on the topic, he notes that at least in the context of pain, our past experiences shape our expectations (and thus our reality). This relationship may explain the ongoing lack of participation in equity markets by most developed world investors. They were in pain due to the financial crisis, and they remain traumatized and afraid of investment risk. Blackrock estimates 58% of cash lies dormant in "returnless" assets. Such investors have been telling themselves a story - that investment assets are unsafe.
Placebos are stronger when there is an element of social complicity (peer pressure). Vance cites a scientist (Koban) whose research finds that "social information might be more powerful in altering the experience of pain than both conditioning and subconscious cues." If others - as reported in the media - believe the same story of pain, then our experience of pain is reinforced and amplified.
Physical pain activates a region of the brain (the anterior insula) that is also activated by financial losses. Investors stay out of the markets when they hear from trusted sources that markets are dangerous. But the collective story of what is risky can change. Along the business cycle, receiving no return on wealth (as Blackrock identified) will eventually be considered riskier than being invested. As this conception of risk changes, cash at first trickles and then later floods into riskier assets.
Grounding in Reality
Our brains try hard to avoid reality when it does not conform to our expectations. Again, Jason Zweig: "After all, information isn’t just bits of data or trivia. It can also be the cause of pleasure or pain. If the information is pleasant, that positive feeling gives you more incentive to pay attention to it. Painful information can push you to ignore it." So we ignore stories that make us feel unpleasant.
“It’s a motivated decision to say ‘no’ to learning available but unwanted information .... People avoid information if it’s going to make them feel or behave or think in a way they don’t want to”—especially any evidence that could jeopardize their belief in their competence and autonomy or could require taking difficult or prolonged action."
~ Jason Zweig citing Jennifer Howell, a psychologist at Ohio University, in his excellent column in the WSJ
So far we've seen that stories comprise much of our reality. These stories often have no empirical basis, but like the placebo effect, they can have a profound impact. Such stories change our neurobiology, our beliefs, and our behavior. The effect of stories is more powerful if there is peer (or media) pressure to believe. When those stories make us feel good (as they usually do), we push away information that contradicts them.
Next we'll explore how those insights can explain market price action, and then move on to examine the role of uncertainty.
Integrating Sentiment Into Models
The feelings underlying our stories are called sentiments. When we express sentiments about an issue like Brexit or Trump, we are publicly declaring the story we believe in. When sentiments about an issue align in one direction, the investors who share those sentiments begin to move prices in tandem. A positive feedback effect between investor sentiment, trading behavior, and price action commences. In the quote above portfolio manager Valentijn van Nieuwenhuijzen observes a fall in sentiment first, and then he reduces equity exposure before the S&P 500 correction of January 2016. He saw a negative shift in the underlying story holding up the stock market.
On the first trading day of this year Valentijn van Nieuwenhuijzen’s laptop pops open. He sees right away that something special is going on. The MarketPsych Indices, the system by which NN Investment Partners [formerly ING] measure sentiment in the market, are coming in…words that are associated with stress and gloom course through digital media...
The main strategist of the Dutch asset manager, with € 187 billion under management, taps the brakes: he reduces investments in shares and raises more cash. Later that week the stress spreads: worldwide stock markets went down sharply...
~ Lenneke Arts & Jeroen Groot. February 28, 2016. “Beleggen met big data wordt langzaam gemeengoed.” Financial Daily. (Translated from the Dutch).
One key to investing with sentiment is to understand whether markets are trending higher along with sentiment and fundamentals, or whether sentiments have become untethered from reality. Moving averages of sentiment are a better-than-random indicator of the prevailing tone of media stories and the market's future.
In trending markets, information is slowly reinforcing a story, and sending prices higher. We can see a rough representation of that relationship in the way that sentiment averages tend to precede S&P 500 price movements since 1998. When the shorter term moving average of sentiment (200 days) is greater than the longer term moving average (500 days), colored green, the market tends to rise. When the 200 day average is more negative, the market tends to follow to the downside.
The apparent reality that sentiment turning points (especially to the downside) are useful timing tools is likely due to the effects of the confirmation bias (described by Jason Zweig in the WSJ citation above). In a positive story environment, investors don't want to hear that the predominant story is turning negative - there is an inertia to beliefs.
However, the inertia of beliefs is broken in the chaos of uncertainty. And it is in periods of uncertainty that sentiment can be most useful in preceding market prices.
As noted above, our data client NN Investment Partners ($220 billion AUM) has been in the media describing their use of our sentiment data in their models. They have explored sentiment data extensively, and one of the insights NN IP developed concerns uncertainty. Studies from behavioral psychologists such as Daniel Kahneman show that as uncertainty rises, people become more irrational. As more stories compete for investor mindshare, volatility rises. However, when uncertainty is resolved, a new organizing theme may emerge. We saw this effect both around Brexit and the Trump election last year, and previously it was seen around the various euro crises. We also see this effect around market turning points.
...[A]fter the election of Trump as president of the United States, or the choice of the British for a Brexit, the emotion was negative, but those markets reacted positively because the uncertainty was gone.
~ Valentyn Van Nieuwenhuijzen quoted in (Dutch) "Hoe NN IP emotie meeweegt in allocatiebeslissingen" by Barbara Nieuwenhuijsen. Fondsnieuws. May 2, 2017.
Housekeeping and Closing
Our capacity to tell stories and believe stories is an integral part of our humanity. Stories must emotionally resonate with our state of mind and the condition of our environment in order to become dominant. Stories are more powerful if there is peer or media pressure to believe them. When those stories make us feel good (as they usually do), we push away information that contradicts them. These stories often have no empirical basis, but like the placebo effect, they can have a profound impact.
My main ambition as a historian is to be able to tell the difference between what's really happening in the world and what are the fictions that humans have been creating for thousands of years in order to explain or in order to control what's happening in the world.
~ Yuval Hariri
Based on the above, for investors it is beneficial to:
1. Monitor the prevailing sentiment,
2. Identify whether sentiment is trending gradually or reaching a speculative extreme, and
3. Isolate whether sentiment is associated with uncertainty (and is thus capable of reversing rapidly).
More broadly, it will be useful in coming months to watch the flow of funds into risky assets -- an indicator that the pain of the financial crisis is finally fully dissipating.
As we saw with NN Investment Partners and the chart above, turning points in sentiment often herald a change in the predominant market narrative and a shift in the price trend. When those stories are enveloped in uncertainty and associated with confusion (as around events), the resolution of the uncertainty often leads to a price rally.
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