EMOTIONAL RESCUE

Investors are in panic mode as markets simultaneously sink.

The rout in stocks and bonds – and the crash in crypto – may be the coda to an era of excessive speculation.

It seems everyone now is bearish, which is a normal over-extrapolation of the current downtrend. Narrative feedback loops turn virtuous cycles vicious and back again with regularity. Such is the power of sentiment, the ultimate driver of anything with a price.

Markets are based on forward-looking perception, not current reality. They don’t move when facts change, they move when perceptions change.

Much of the time it is easy for market observers to believe in news causality. Financial markets fluctuate constantly, and news comes out constantly, and sometimes the two elements coincide well enough to reinforce commentators’ mental bias towards mechanical cause and effect. Yet there are many days when markets have large moves in the absence of major news events.

Markets will also move in a direction opposite the way most might think. On the day Russia invaded Ukraine, for example, the stock market made an interim low that held for over two months.

It’s axiomatic that someone must buy the high, and someone must sell the low. Peaks and troughs are forged by emotional extremes, not by abstractions like valuation or growth rates. Herding behavior is complicit as an offspring of mass psychology.

"The vast majority who buy when prices are elevated and sell when markets fall, do not feel nervous and fearful upon acting; they feel relieved. They do not know they have increased their chances of losing or reduced their chances of gaining because unconsciously they have acted to reduce the discomforting feeling of missing out on gains or risking losses. Because their risk increases by both sets of actions, we may confidently conclude that such behavior is non-rational.” - The Socionomic Theory of Finance.

Odd as this may sound, the following picture is so bearish, it’s bullish. Sentiment is often useful as a contrarian indicator, particularly at extremes. Like a beachball underwater, energy is released by a propulsion in the opposite direction.

Market sentiment is the backbone of our quantitative investment strategies. We have found that analyzing price action is the best way to capture investor psychology.

Price leaves footprints of valuable information. Clues stitched together into a contextual latticework. Empirical evidence, not theory.

Any informal, intuitive approach to decision making is especially likely to fail when phenomena are complex or highly random, two prominent features of financial market behavior. Objective methods, on the other hand, with well-defined repeatable procedures can issue unambiguous market signals. This allows for algorithmic testing on historical data and evaluation in a rigorous quantitative manner.

Market sentiment lends itself to objective analysis in many ways. We can quantify the amount of participation in a trend, for example, by tracking the number of advancing and declining stocks. Or by analyzing money flow and on-balance volume. New highs versus new lows, and volume-weighted price levels are other quantifiable indicators.

All data must be subject to statistical inference to find any real value. Just as taking a stock tip from a friend has a low probability of success, taking back-tested results at face value may be a data miner’s fool’s gold.

But would you rather rely on a dice roll, or on Moneyball?