"Trading the News"

Understanding Market Psychology: Anticipating the market’s reaction to a perceived change in the fundamentals

This week, I would like to impart upon my readers hard-learned lessons from “trading the news”. If you’ve ever been caught in a situation in which the market reacts differently to new information than you would have expected, and you do not understand why, you should probably read on...

In the most basic sense, traders follow the news because it contains up-to-date information about the market fundamentals. Whether we base our trading decisions on the latest economic reports, earnings reports, weather reports, world events, or policy, we are in essence interpreting the fundamentals. 

If you’ve read up on our philosophy, you may already know that we believe that it’s impossible to understand the fundamentals in their entirety. If market fundamentals are defined as anything that can affect market supply and demand, then they are largely dictated by crowd psychology. In other words, supply and demand are determined by the combined perceptions of all market participants. Psychology is not a "hard" science, however. If the best possible understanding of an individual’s psychology is fuzzy at best, then understanding the systemic psychology of an entire marketplace is out of the question.

Thus defined, fundamentals can encompass almost anything yet are paradoxically also market specific. But just because the markets are impossible to understand and predict, does not mean that they react randomly to a change in their fundamentals. It is also does not mean that we cannot profit from trying.

In the most simplistic sense, good news should be good for the market, while bad news should be bad for the market. When the employment situation improves, for example, we might expect equity indices and treasury yields to rise. To build on this idea, good news is defined as anything better than expected, bad news is worse than expected, and neutral news is on par with what is to be expected. To define expectations, traders and investors look at surveys and consensuses for economic releases, forecasted earnings for companies, and assess how the current news cycle fits into a broader context with regard to both its nature and frequency.

However, simplistic notions can mislead. For example, assume that the markets have taken a beating from a string of negative news and much poorer than expected economic indicators. However, earnings remain on-target. When payroll comes out indicating slightly lower than expected, the markets rally. If this result seems counter-intuitive, it’s because it is. These kinds of discrepancies exist because there are differences between market participant expectations, and market sentiment.

In the former example, markets rallied on news that indicated the economy was performing worse than economists’ predicted. The reason for this was probably because the market had already factored in an extreme form of pessimism. When news came out indicating that the underlying economic situation may not have been as been as expected, the market reverted to what it should have been based on company earnings.

This observation, (which I assure you, is based on my past experiences) indicates that traders need to not only examine what “experts” expect versus is systemically expected, but also examine what expectations are already factored into price versus what expectations are not. While some might argue that all information is already factored into price, this is not possible because no one has complete knowledge of the present, not to mention the future. In order to determine what information is factored in, traders need to form a subjective assessment of market sentiment. Is the market factoring in negative sentiment, positive sentiment, or neither?

Instead of anticipating the effects of news from a single dimension, we need to anticipate it in terms of market expectations as well as market sentiment. The following table anticipates market direction (for equities) based on several market conditions:

This methodology can be further utilized to more accurately anticipate the effects that fundamentals have on the equities markets by examining the relationship between earnings versus sentiment.

Another application might involve examining the relationship between equity valuations (based on earnings) and other fundamental factors.

Interestingly, the above table demonstrates one way to determine what emotions are already factored into the market price. If equities are priced below earnings valuations, the market probably factors in a degree of pessimism. If equities are priced above earnings valuations, the market probably factors in a degree of optimism. And if equities are priced on-par with earnings, the market is probably neutral.

While the above tables and statements are true for equity markets, they can easily be changed to reflect the effects of fundamentals on other markets.

While they may be counter-intuitive, the views expressed herein are not controversial. In fact, they confirm the conventional wisdom of the great Warren Buffet, who states, “Bull markets are born on pessimism, grow on skepticism, peak on optimism and die on euphoria”.

In order to form an accurate interpretation of a market’s directional tendency, we must first discard the idiosyncratic blinders that drive the masses into alternating bouts of hysteria and euphoria. When everyone is sure that market can only go down more, there is the contrarian argument that says it cannot if those expectations are already factored in. For example, J.P. Morgan, who, after hearing his shone-shiner’s advice to buy stocks, shorted the market right before the crash of 1929 to make millions. This basic lesson is that when everyone is already as optimistic as possible, the market factors this in, and more upside is unlikely. Likewise, when participants are already as pessimistic as possible, the market price factors in an extreme form of pessimism, which indicates that a bottom is likely to form. These observations do not disallow for extreme occurrences to drive a very optimistic market higher, and a very pessimistic market lower, however.

There are limitations to estimating market sentiment, however. It is an easy enough task to say that sentiment matters, but much more difficult to assess it and apply it. Because market sentiment depends on participant psychology, any assessment is inherently subjective. To that end, various indices exist that attempt to measure market sentiment (see http://www.sentimentrader.com/, http://esi.dowjones.com/). Others claim that market sentiment can be measured using various technical indicators including candlestick patterns (see http://www.yourtradingcoach.com/Videos-Technical-Analysis/Candlesticks-Vol-2-Candlestick-Sentiment.html). There is also the argument that sentiment can only be accurately measured by having one’s “finger on the pulse”, by keeping oneself up-to-date and well-informed. I, for one, believe that the best indication of market sentiment can be garnered by contrasting price versus value. A good axiom to live by is, price is what you pay, value is what you get in return (paraphrased from Warren Buffet).

There is no right or wrong way to probe the market’s mood. If we left something important out, please feel free to insert your own method. Whatever method you decide is best for measuring market sentiment, you are probably correct.

As always, we appreciate your comments and feedback. Good night and good luck.