Why Wall Street Needs a Fecal Transplant: Russia, Insider Trading, and Your Microbiome

The first time I visited Russia was in 1992, and the U.S.S.R. had recently broken apart. I overstayed my visa - I had entered on a visa for the Soviet Union, but it no longer existed - so I was able to wander around Russia and Central Asia for a few weeks enjoying the fascinating disorganization of the political transition.

Toward the end of my travels in Russia I encountered an old woman sitting on the sidewalk who was selling a single basket of dirty strawberries. That's all she had - one basket of red, dirty, strawberries sitting in the middle of an otherwise empty tablecloth. I hadn't seen any fresh fruit or vegetables up to that point - these were still the years when all fruit and vegetable production went into State-owned factories and emerged peach-colored and flavorless in brown jars. (All jarred fruit in the USSR - regardless of whether it entered the factory as a strawberry, pear, or mango - emerged from the cans peach-colored and flavorless). So craving fresh fruit, I quickly bought the dirt-covered strawberries, scraped off a few chunks of dirt, and popped one into my mouth.

The strawberry seller said something urgently to me in Russian, but I didn't understand. I smiled at her. I proceeded to gulp down another strawberry. At this point several of the vendors around her were also talking to me rapidly. I smiled bigger - my default traveler strategy when not comprehending what was happening - and ate a few more strawberries. They looked at me with a mixture of astonishment, mirth, and concern. I was accustomed to being watched with astonishment and mirth, but their concern was unsettling. Nonetheless, I had no idea what they were trying to tell me, so I left with a spasiba! and a wave. As I walked away the vendors tried to smile at me, but I thought I could see their smiles distorted by underlying grimaces. They were trying to tell me something, I realized. Something was wrong, but what?

The next day I felt a sharp pain in my abdomen, and I involuntarily doubled-over while walking. The stabbing pain went away for a few minutes, but then three stabs of pain returned. Within an hour I was hosting a knife-fight in my gut. By the end of the day each wave of pain led to an explosive event. And as I soon discovered, I had eaten a strawberry covered in human feces.

But more on that later.

This month's newsletter is inspired by a paradigm shift underway in modern medicine. Research into the complex relationship between our diet, our gut microbiome, and our mental and physical health is redefining how we understand human biology. This new understanding has profound implications for how theorists model financial markets and investor behavior.

This newsletter first examines the science of the microbiome-gut-brain axis. We then go on to explore implications of this new understanding for how we think about markets, regulations, and insider trading. In the Researcher's Corner we example an often neglected side of the feedback loop between market prices and investor behavior. We then discuss what you can do to optimize your own health based on the latest science. And finally we review recent psychology-based investment ideas.

The Microbiome - Gut - Brain Axis

Our gut bacteria also play a role in the manufacture of substances like neurotransmitters (including serotonin); enzymes and vitamins (notably Bs and K) and other essential nutrients (including important amino acid and short-chain fatty acids)..... [W]hen gut microbes from easygoing, adventurous mice are transplanted into the guts of anxious and timid mice, they become more adventurous.

~ Some of My Best Friends are Germs. Michael Pollan, May 15, 2013, New York Times.

Leading financial theorists such as Andrew Lo have noted that markets are adaptive systems, more prone to follow the laws of biology than artificially constructed linear models. However, until recently our understanding of the laws of biology were simplistic and sparse. Fortunately, a new generation of researchers, aided by big data and undaunted by statistical complexity, is sorting out the key relationships between biology and behavior, and the gut is playing a key role in understanding physical and mental health.

Warning - skip the rest of this section if you're not interested in reading some dense biology.

As this comprehensive three-part review article points out - Intestinal microbiota, probiotics and mental health, researchers have been exploring the diet-gut-brain interaction for over 150 years, but the approach largely fell out of favor in the 1930s.

The collection of bacteria in our digestive tracts - our gut microbiome - has an estimated mass of 1-2 kg, contains 100 trillion organisms, and together those organisms possess 100 times the number of genes in the human genome. These bacteria also affect how we think and behave. For example, brain serotonin metabolism is altered by the colonization of bifidobacterium in the intestinal tract, and in this study antibiotics administration increased anxious behavior in mice, and a fecal transplant from a happy-go-lucky mouse into an anxious mouse reduced anxious behaviors. There is a significant amount of such published evidence indicating that the gut biome directly affects animal mental state and behavior.

For the most part, the relationship between the gut microbiome, diet, and behavior is poorly understood. However, bacteria that are common in traditional fermented foods (miso, kimchi and sauerkraut, for example) and yogurt have been found to decrease stress reactivity, and are now featured in probiotics. For those beneficial bacteria to prosper and grow, they require prebiotics such as plants (fruits and vegetables) and fiber (nuts and legumes). Fiber in our diets often traps nutrients and carries them further down the digestive tract, encouraging the growth of beneficial bacteria. Easily digested foods, such as processed foods, starve some of the more influential bacteria further down in the intestines.

Beyond the foods and bacteria we eat, the permeability of the intestinal mucosa itself influences whether toxins and inflammation-inducing molecules can enter the bloodstream and cause or provoke damage. Leaky gut syndrome describes a condition in which inflammation of the gut lining leads to increased permeability of the intestines. As a result of this permeability, large potentially allergenic molecules (such as glutinin from wheat gluten) may pass into the bloodstream. Additionally, endotoxins of gram negative bacteria - which are more common in the intestines when we eat a diet with little plant fiber - also may pass into the bloodstream, stoking systemic inflammation, worsening autoimmune diseases, and increasing the permeability of the blood-brain barrier.

Factors that caused increased leaky gut include gluten protein (in up to 30% of people), simple sugar intake without fiber (such as in soft drinks), and some processed foods. Protective phytonutrients in spices and tea such as in curcumin (turmeric), cumin, and green tea are protective against leaky gut. To simplify a complex story, both psychological stress and eating a diet high in processed foods and low in plant matter contributes to systemic inflammation, numerous illnesses, and alterations in our thinking towards anxious and depressive cognition.

Russian Rebound

My Russian strawberry consumption gave me a bad case of the flagellate parasite Giardia, which I hosted for three months, until my own body mounted an adequate immune defense. Giardia is a parasite that breeds in the intestinal lining, and it's unpleasant. That said, there are actually advantages (in addition to the obvious disadvantages) of living in an environment where a variety of microbes dwell on your food.

Medically speaking, rates of allergies and autoimmune disorders tend to be lower in dirty environments (the hygiene hypothesis). For example, this study compares rates of illness for ethnic Finns living in adjacent towns on either side of the Finno-Russian border. Those living in Finland had generally adopted a Western lifestyle (processed food, running water, etc...), while those on the Russian side generally had not. In terms of disease incidence, the rate of allergic diseases was significantly higher among the children raised in Finland. Recall, allergic diseases occur when an over-excitable immune system turns against a common environmental allergen. The rates of pathological infections were higher in the Russian children, keeping their immune systems busy. According to the hygiene hypothesis, without some external pathogens - some grit in our environment - our immune system may turn on itself as it did with the Finns.

Russia and Pakistan are gritty places. For 2013 so far we've had buy signals on both the Russian and Pakistani stock markets based on our country rotation models - long term investment models derived from the sentiment and macroeconomic buzz in the global news flow. Investing in Pakistan has worked out tremendously for us, and it was recently replaced by India in the rotation. Russia has not worked out well. But that may be about to change.

We've had several positive indicators on Russia recently. In particular, our daily-updating PMI simulations, based on the news flow, indicate that the economic climate is improving in Russia. Putin's government is planning stimulus including infrastructure spending. Our indicators often forecast the PMI several months ahead, so we should see a rising PMI in Russia over the next few months. See the following depiction of Russia's efforts to increase growth as extracted from the news flow.

The political climate in Russia is worrisome. Russia jailed opposition leader Alexei Navalny on absurd political charges. However, Russia then released Navalny a day later. Could that possibly be a positive sign? Yes. It unnerves international investors, but it also shows that the Kremlin is responsive to public pressure. Yes, there is grit, which keeps foreign money out, but the system is cleaning itself up - positive momentum.

Personally, I'm not as comfortable recommending buying into Russia as I was into Pakistan. One factor holding Russia back is that many investors already entered the Russian market over the past decade, and they'll be happy to cash out as the market rises. That overhang, and the fact that Russia is already well-known by foreign investors, means that Russia won't see 60% annual returns like Pakistan.

However the data is fairly convincing that recent negativity on Russia is overdone. Russia may be on the cusp of better growth and - perhaps - more political liberalization than the consensus pessimism merits. As in the case of Pakistan, moving from very bad to bad is a net positive for market prices. Russia's grit - as long as it is gradually cleaned up - is good for the market's long term outperformance.

Leaky Gut Syndrome, Regulatory Autoimmune Disease, and SAC Capital

Man is constantly standing, as it were, on the brink of a precipice; he is continually on the threshold of disease. Every moment of his life he runs the risk of being overpowered by poison generated within his system.

~ Bouchard CJ. "Lectures on autointoxication in disease." Philadelphia: F.A. Davis Company; 1897.

A more modern problem with markets relates to the hypertrophy of regulatory agencies - the market's immune system. When regulators have law-breakers to ferret out, then they keep the system healthy. But when they run out of clear targets such as Madoff, then they create autoimmune disease - beefing up their defenses to absurd levels and attacking the system on the inside.

Don't get me wrong, there are definitely pathogens on Wall Street. The problem is, most of them operate within the law. Fabrice Tourre (Fabulous Fab) - acting out of personal greed - benefited from knowingly selling toxic CDOs to unwitting customers. Yet the vast majority of his fellow toxic-asset salesmen got off without an indictment because some unethical activities are perfectly legal on Wall Street.

I'm no expert on the SAC Capital case, and I don't know if the firm is guilty of creating a culture of trading on inside information. SAC Capital has the highest fees in the industry because the investment performance is among the highest. SAC currently has 1,000 employees and over 500 employees actively involved in the investment process. Since 1993, more than 1,000 active managers and traders must have passed through SAC, and the SEC has indicted around 10 to 15 of them. That's less than 1.5% of all involved in trading over that period. Consider that 1% of the U.S. population can be diagnosed as psychopaths (and arguably the percentage is higher on Wall Street). I haven't seen the SEC evidence, but based on some simple numbers, an indictment of the entire firm seems like overreach - perhaps a sign of regulatory autoimmune disease.

As any SEC investigator could tell you, traditional financial theory asserts that markets are efficient, so the only advantages to be had are likely through an unfair edge. Steve Cohen and his portfolio managers, according to traditional theory, cannot possibly be making money through intuitive trading skill, therefore they must be cheating. Seen through the eyes of the SEC, he's guilty until proven innocent. From what little I understand of Steve Cohen's trading, he's a genius at identifying market price and information patterns and extrapolating future trends from them - called tape-reading. Cohen has a keen understanding of the complex interplay among information, investor psychology, and prices themselves. Even during the period of SEC investigation, SAC has continued to outperform.

Researcher's Corner: Hospital Admissions and Stock Market Gyrations

[T]he essence of a speculative bubble is a sort of feedback, from price increases, to increased investor enthusiasm, to increased demand, and hence further price increases.

~ Robert Shiller. 2002. Bubbles, Human Judgment and Expert Opinion. Financial Analysts Journal.

I was a psychiatry resident in the San Francisco area during the tech bubble meltdown (2000-2004). Working in the psychiatric emergency room I treated several dot-com millionaires who presented to the emergency room anxious and depressed about falling market prices and the diminishing values of their stock options. Inevitably they asked for financial advice - "doc, do you think the market will come back?" Their anxiety was situational, and they were desperate for a shred of certainty. The experiences of these dot-commers fits a pattern identified by Joey Engelberg and Christopher Parsons from UC San Diego in their recent paper, "Worrying About the Stock Market: Evidence from Hospital Admissions."

Joey Engelberg is a rising academic star at UC San Diego with innovative publications based on text-mining, search frequency, and other proxies for investor emotion. In his new paper, Engelberg and Parsons note that while much prior research investigates the impact of investor psychological states on asset prices, few studies investigate how market prices - especially large changes - themselves impact investor psychology and behavior. As Shiller suggests in the opening quote, market prices may be driven by a positive feedback loop. In order to understand the totality of market price action, we've got to understand the feedback loop.

The authors find strong evidence of a market price impact on investor psychology in a surprising place - Southern California hospital admission records. The most vivid example of the effect is in the following chart from the paper, "Abnormal Hospital Admissions and the 1987 October Crash:"

In this case, the impact of market price action on a single day's hospital admissions is dramatic. The authors find the pattern is much more pervasive than a single day, with the entire bottom quintile of return days (the worst 20% of 7,319 trading days sampled from 1983-2011) being significantly correlated with mental health admissions to Southern California hospitals. The effect is stronger when an index of the stock returns of only California firms was used, further validating the finding.

Just as the relationship between our diet, our gut microbiome, and our mental state is a complex feedback loop, so is the relationship between market prices and investor psychology.

So far in this letter we've seen how investor psychology operates in a feedback loop with market prices. We've also explored how grit can keep markets healthy and an overactive regulatory system can attack the system from the inside. Now we will turn our attention to the basic steps you can take to ensure your own system is running as smoothly as possible.

Tending Your Microbiome

"It's a fact - your doctor will agree - that your attitude toward things in general is largely

influenced by the condition of your intestinal tract."

~ "Walker-Gordon Acidophilus Milk: Keep a cheerful outlook". Advertisement. New York: Times;

1932:3.

The interrelation of diet, the gut microbiome, and our mentation and physical health is incredibly complex. What we know so far is that the modern diet is impairing our physical health (witness the obesity, allergy, autoimmune, and diabetes epidemics linked to the western diet) and mental health (we see much higher rates of mental disorders in developed vs emerging economies). What is the most successful intervention for the disorders related to sterile modern food and society?

Evidence is accumulating that fecal bacteriotherapy (fecal transplant) facilitates treatment of numerous conditions including autoimmune disorders, obesity, diabetes, and neurological conditions such as Parkinson's disease. But I'm not recommending that. Let's try the easier steps.

What are the individual take-aways from the latest research?

Diversity and roughage in our diets (and lives) improves our mood and our resilience to stressors. Dietary modifications such as increased fibrous plant-based foods, cultured and fermented products, omega-3 fatty acids, green tea, turmeric (curcumin), and cumin appear to strengthen gut microbiota populations. Decreased gluten (for some people) and decreased psychological stress reduce leaky gut.
Consider reducing refined sugars and fructose (sodas) and substituting with fruit or honey. Fruit and honey contain phytonutrients that facilitate the growth of good bacteria and inhibit the growth of bad.

Take-aways for global investors?

Look for grit in your global investing, but avoid pathological regions with un-enforced regulations, which facilitate corruption. Grittier markets have higher returns over time.
Smart regulation enforced by common-sense laws is important. Smart regulation is present in a few countries such as Singapore and Australia. In general, regulation is improving - in fits and starts - worldwide.

Trading Corner

In last week's weekly commentary we made five specific one-week equity recommendations. Four out of the five were correct on direction, and the average return of all five from the Monday open to the Friday close was 2.5%.

As you can see below, our current social media-based Bubbleometer for the S&P 500 from 2010-2013 is not peaking, despite recent all-time highs in the S&P 500.

Please subscribe for our specific recommendations and market outlook.

Housekeeping and Closing

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 fundamentals and are driven by psychological factors.

Institutions please contact us about seeing into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor market psychology and macroeconomic trends for 30 currencies, 50 commodities, 120 countries, 40 equity industries, and 5,000 U.S. and global equities extracted in real-time from billions of social and news media articles since 1998.

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.

In addition to our home base of New York, we will be speaking in several cities and countries in the near future. Please contact Derek Sweeney to book us for a talk or training at one of your events: [email protected], +1-866-727-7555.

Happy Investing!

Richard L. Peterson, M.D. and The MarketPsych Team

Selected References

Norman HJ: Lactic acid bacilli in the treatment of melancholia. Br Med J 1909, 1:1234-5.
Bested, Logan, and Selhub. 2013. "Intestinal microbiota, probiotics and mental health."
Karen-Anne M Neufeld, Nancy Kang, and Jane A Foster. 2011. "Effects of intestinal microbiota on anxiety-like behavior." Communicative and Integrative Biology. 4 (4), 492-494.
Dinan TG, Cryan JF. 2012. "Regulation of the stress response by the gut microbiota: implications for psychoneuroendocrinology." Psychoneuroendocrinology. 2012 Sep;37(9):1369-78. doi: 10.1016/j.psyneuen.2012.03.007. Epub 2012 Apr 5.

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