June 06, 2014
Market Monsters, Banana Peels, & a Buy-On-Pessimism S&P500 Strategy
The Monster in Your Closet
When they were younger, my children were afraid of monsters. Usually the monster lurked in the closet, but sometimes it crouched in a dark corner or under their beds. When seen, it looked like a vampire or maybe a witch or both, but most of the time it remained hidden, waiting to strike at the moment they finally relaxed.He who fights against monsters should see to it that he does not become a monster in the process. And when you stare persistently into an abyss, the abyss also stares into you.
~ Friedrich Nietzsche
For my children the fear was absolutely gripping - the monster FELT real and they positively KNEW that the monster was coming for them.
As any parent knows, opening the closet and telling a child, "See there's no monster, nothing is going to eat you" doesn't soothe the fear for long. Just because my youngest couldn't see the monster, he didn't feel less threatened. After one such episode - me rationally explaining that we could not see the monster thus it wasn't real - he told me, "it's waiting to come back after you leave."So I asked, "what's the worst that could happen?"
"It's going to get me," my youngest told me.
"What does that mean?"
"It's going to eat me, until there's nothing left. Until I'm all gone."
It finally dawned on me, this monster couldn't be killed with logic.
The Monster in Your Mirror
As investors we sense monsters on a daily basis. We fear that we'll miss an opportunity. We fear that we're not keeping up with our peers. We fear that we'll lose money. Those are our monsters. They lurk in the shadows of our consciousness.
Yet as the opening Nietzsche quote suggests, fear of those monsters leads us to make even more predictable mistakes with our money. The real monster is in us, and it is aroused by our own fear of it - inflicting death on our portfolio by the thousand cuts of frightened trading - buying high and selling low again and again.
In today's newsletter we'll look at the monsters lurking in our closet. We discuss how expectations of monsters drive stock prices, and how to harness others' fear of such monsters in our own trading. One of our resident predictive analytics gurus - Changjie "CJ" Liu - reveals how investor expectations of the worst fuel a profitable daily S&P 500 forecasting strategy, buying when others are fleeing in fear. At the end of today's letter we turn away from the monsters, teaching you a mental hygiene exercise to help you use the tremendous power of positive belief to your advantage.
How to Forecast the S&P 500
Over the years you've heard investors such as Warren Buffett give the advice "buy when others are fearful." You may have also heard technical analysts note that price typically revert to "Fill the gap." When investors fear the worst for that day's price action, and the Open of the S&P 500 sells off, CJ found solid evidence that such a peak in fear is an excellent time to buy. Saavy investors buy on fear at the S&P 500 Open, exactly at the time when others are lining up to flee the monsters they see in the market.[Investors] should try to be fearful when others are greedy and greedy when others are fearful.
~ Warren Buffett
Using the Thomson Reuters MarketPsych Indices (TRMI) priceForecast index for the S&P500, in our true-minutely data feed, CJ aggregated the minutely priceForecast scores for the S&P 500 over the four hours prior to the S&P500 Open.
CJ's research identified a broad reversion pattern in which a high price forecast in the news media during the four hours prior to the daily S&P 500 Open is followed by an average decline of prices from the S&P 500 Open to that day's Close. The opposite was also true, but even more so.
When both the priceForecast TRMI is low, and the past day's market return is negative, the average returns of this strategy increase. The monograph describing CJ's work is available to TRMI researchers and clients - let me know if you'd like a copy.
In my interpretation, and to put it in the context of our deepest fears, fear of a down day in the market after a prior down day frightens investors. With the news media forecasting another bad day, fear hits a climax at the Open. Many more sell orders are placed to execute at the open. But from that opening selloff, the market tends to rise over the course of the day.
See the equity curve below from applying this strategy for both longs and shorts. The in-sample period is 2001-2012, and the out of sample period is 2013.
While the average return for both longs and shorts was about 10 bps (0.10%), the average for thee longs was much better. Remember that the long positions are taken when prices are forecast to be down on the day. The average return from buying on a negative priceForecast before the open is more than 0.36%, trading on 10% of days in the recent period.
It appears that understanding one fear of other investors (losing more money after a bad day) contributes to a profitable trading strategy.
As an individual investor, remember not to listen to the media, and always be careful when after a down day in the market followed by pre-opening media pessimism. If you feel the need to sell in such conditions, most likely you will be better off waiting a day before pulling the trigger.
Market expectations are paradoxical. On the one hand, we generally want to invest in pessimism. The best market performance is after a period of negative market expectations. On the other hand, in our personal lives, positive expectations of ourselves drive achievement.
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2 Minutes Daily To Create the Life You Want
In a review of research trials on Anti-depressant medications submitted to the FDA for drug approval, the strength of the placebo response averaged 82% of the active drug response [1]. For treating several anxiety disorders, the placebo response is even stronger. The power of belief - positive beliefs in the case of placebos - is the most under-appreciated psychological tool we have at our disposal.The mind is everything. What you think you become.
~ Buddha
We can capitalize on the power of belief through creative visualization. The following section will help you develop a simple but powerful image. The daily visualization of this image will help you live an even more successful life.
Using as many adjectives as possible, describe what it is like for you to be in a peak mental state in each situation:
1. When I perform at my best in my primary relationship (spouse, partner, best friend, or family member), I feel ... (For example: “fun,” “happy,” “free,” “secure,” “trusting,” “playful”)
______________________________________________________________________
2. When I perform at my best in investing, I feel ... (For example: “analytical,” “in the zone,” “responding with skill,” “competent,” “confident”)
______________________________________________________________________
The above adjectives reflect your peak mind-sets.
Now imagine yourself investing in your peak mindset - in a scenario involving controllable aspects of the investment process. You are executing at your best. Close your eyes and visualize yourself with those characteristics for 30 seconds.
Next see yourself in a scenario involving an investment difficulty - how to react to confusing information, unexpectedly bad performance, etc.... Close your eyes and visualize yourself with the peak performance characteristics that will help you overcome such a challenge.
Holding a positive image of ourselves literally changes our brain chemistry, “priming” us for a more effective and successful life.
Now identify a single, positive image that rekindles that feeling of you of you at your best - in peak performance during good times and bad. Examples of images include the face of a role model, a memento from a prior success, a specific location, an animal that embodies those traits, etc...Whatever the mind of man can conceive and believe, it can achieve.
~ Napoleon Hill
My peak mental image is: ____________________
If you imagine that image, and associate it with living at your best every day, you will gradually take on those positive characteristics.
We all brush our teeth daily. Imagine what would happen to your breath if you didn't brush your teeth? (Yikes!). Yet most of us don't have a daily practice to clean and prime our minds. Visualize living as your best possible self for 1-minute, twice daily. This is your daily "Mental Floss" to keep your mind fresh, productive, and creative.
Slipping on Banana Peels
So what happened with my children's fear of the monster?
After several failed attempts at logically debunking the existence of the monster, I realized I needed a shift. Rather than experiencing the monster as an invincible beast, my children needed to regain control of their perspective.
I told my youngest, "Why don't you put a banana on your floor."
"Why?" he asked.
"If the monster is feeling hungry, then he can eat that instead of you."
My son looked intrigued.
I went on, "And anyway he might slip on the banana peel and fall down."
"Huh!" my son said with a chortle.
Now the tables were turned and humor entered the scene.
So I went on, "And if he falls, then he'll cry. So let's keep a band-aid ready in case he gets a bump when he slips."
My youngest responded, "That would be so funny!"
Thus the monster was humanized and the situation placed under his control.
And wouldn't it be fun if - with some self-reflection and practice - you took control of your own market monsters?
Housekeeping and Closing
We're in London monthly, and we are speaking at this conference in late June: “4th Annual Conference: Behavioural Models & Sentiment Analysis Applied to Finance” 18 – 19 June, 2014.
We are presenting at many events, public and private over the next few months. Please contact Derek Sweeney to book us for a talk or training at one of your events: [email protected], +1-866-727-7555.
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, 130 countries, 50 equity sectors and indexes, and 5,000 individual equities extracted in real-time from millions of social and news media articles daily.
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