Safe Haven?

It seems like only yesterday that we analyzed the behavior of prison bullies and the parallels with political brinksmanship in this newsletter.

Today we'll explore the psychology of self-righteous anger and paranoia as it relates to the current political impasse in Washington D.C. – first the government shutdown, and then October 17th debt ceiling and potential default.

The U.S. government political paralysis negatively impacted global investor psychology, driving a flight-to-quality out of U.S. equities last week into the Euro, Yen, Canadian Dollar, and other safe-havens. As we've discussed in prior reports, the game theory behind such brinksmanship requires this game of chicken to end badly, despite the short-term negative outcomes for the economy and political system.

Yet the price movements are not entirely what they were expected to be. The U.S. government shut down last night, and then gold fell more than 2% and U.S. stocks rallied today. What's happening? This is one of the most classic and enduring patterns in financial markets, which will delve into in this newsletter, called "Buy on the Rumor and Sell on the News."

Working Through Paranoia

Among Washington politicians, there is a sense that we're witnessing "paranoid theater" – that self-righteous anger is being used strategically to stymie the power of one side in the funding debate. Yet polls show an intense political polarization in the American public. If both sides see the current impasse as theater, and not a substantive dispute, then we're due for pain before a solution will be pushed through by the political leadership.

In a past newsletter on the Iranian pursuit of nuclear weapons, we discussed the game theory of young male elephants. When a player in a game is in a weaker position, the only way to get additional power is to fake crazy-violence like an elephant in "must". To quote at length from this fascinating 2011 Op-Ed in the NYTimes by professor David Barash:

To achieve their mating goals, male elephants will sometimes play games of chicken, with one individual essentially giving the impression that he is crazy and has become an irrational player in a game premised on shared rationality and predictability.

It's a tactic that works surprisingly well, because male elephants can in fact become temporarily "crazy". One of the most terrifying sights in the animal world is an elephant in a state of must: Huge bulls, oozing a weird, foul-smelling, greenish glop from glands near their eyes, behave with violent abandon, taking risks and defying the basic rules of pachyderm propriety (and also giving rise to the term "rogue elephant"). Facing an elephant in must, other elephants — not to mention people — are well advised to get out of the way.

When working with someone who is paranoid, it's important to make an effort to understand their internal logic. However, if they are in a state of must, then it's best to get out of the way. What we see in Washington is two parties getting out of each other's way. We don't see trust-building, and we don't see a desire to understand. Fundamentally, it's political theater.

How will the political theater end? In this case, public opinion is slightly inclined to blame the Republicans for the shut-down, and as a result, resolution will likely come from caving in on the part of the Republicans.

For now there is a fair amount of complacency. We're likely to see the drama build until there is more pain reflected in market prices. A mild stock slide into the debt ceiling deadline on October 17th is likely.

Sell on the Rumor, Buy on the News

As legislators try to inspire market-moving drama this October, it's important to keep in mind that we have fixed deadlines– first the Government shutdown (last night) and now the debt ceiling increase on October 17th. When a fixed date is known in advance, the power of anticipation and relief to drive prices can be used strategically.

Today we're seeing a rally in the U.S. stock market. That's right, the U.S. Government shut down and the market rallied. Sounds odd, but keep in mind that we had a one week selloff into the shutdown. This is one of the most enduring patterns in financial markets – the “Buy on the Rumor, Sell on the News” pattern (BRSN). I'm a fan of this pattern, and here is a 2005 book chapter (Proof) I wrote on the topic.

In the case of the U.S. government shutdown, we saw the BRSN pattern in gold (which was up strongly, but is now down more than 2% today as I write this), but in U.S. equities we saw more of a Sell on the Rumor, Buy on the News (same process as BRSN, but inverted), with U.S. stocks up more than 0.5%. We're going to see the pattern again as we approach the October 17th deadline for the debt ceiling raise.

We also saw the BRSN effect recently after the iPhone 5S and 5C were announced. Considerable hype surrounds Apple product unveilings. In fact, the Wall Street Journal reported on a consistent BRSN pattern around Apple's MacWorld tradeshows as early as 2001. And the pattern continues as you can see in the chart below:

The Summer 2013 Apple chart shows that when a short-term average of our MarketRisk index deviates substantially from the longer term average, then an asset is primed for a price move. We see this especially around anticipated events.

While Apple (AAPL) dropped for about a week after the new iPhones were unveiled, it rallied shortly thereafter as unexpectedly long lines of customers camped out to buy one.

What Drives Asset Prices?

As you can see in the Apple (AAPL) chart above, our team of visualization experts has been hard at work developing new and interesting techniques for finding value in sentiment data for our website's Professional Subscribers.

We've been particularly keen to understand how sentiment drives asset prices. Does sentiment lead order flow and fuel the formations of technical setups? Or does sentiment follow market moves? These are questions we've been working through, and you can see some of the tools we're using to understand the drivers of asset prices in the following images.

We added MACD coloring to the charts on our website to capture sentiment-driven momentum and reversals in prices. In this case, we see evidence of predictability of trends.  Below is a chart of S&P500 Sentiment average cross-overs from 2010-2013.

In order to understand at any given time what influences are driving prices, we created classification trees. Our currency, commodity, and ETF Classification Trees indicate the drivers of asset prices in over past periods, including Fundamentals, past Price Action, and Sentiment.  Please read the explanations before diving in, as these models require some thought to understand.  Here is an example of the recent drivers of the DJIA 30:

We also added global sentiment and macroeconomic maps, so global strategists can track global events in the newsflow.  See global MarketRisk for August 2013 below:

Trading Corner

The above S&P 500 Sentiment MACD chart shows that sentiment for the S&P 500 has turned negative since the beginning of August. Additionally, we’re likely to see lot of interesting price movement in fixed income, gold, and equity markets as the U.S. debt ceiling approaches.The above S&P 500 Sentiment MACD chart shows that sentiment for the S&P 500 has turned negative since the beginning of August. Additionally, we’re likely to see lot of interesting price movement in fixed income, gold, and equity markets as the U.S. debt ceiling approaches.

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Housekeeping and Closing

We’ve got a busy 2013 ahead, with speaking engagements in the USA in Toronto, Philadelphia, Orlando, San Francisco, and Providence, and globally in Berlin, Warsaw, Panama City, and Accra. 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.

If you represent an institution, please contact us for research reports specific to markets or assets you are watching. We find that our psychological research can help analysts and portfolio managers understand price action in markets that have deviated from fundamental drivers.

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