The first person I heard keeping a track of DOW on a day to day basis was a business school senior of mine from the class of 1997. Little did I know then that in barely ten years, the world will get glued to DOW daily and intraday movements. And nothing will matter more than where the Dow was headed. We are in the age of DOW, and DOW psychology rules. The grip is so powerful that an emerging market broker in Romania after a market update to his client starts talking about what the client is interested in most, the bailout meeting. The respective client will be missing the UEFA CHAMPIONSHIP match between CFR CLUJ and CHELSEA to watch the bailout meeting at home.

DOW is the global pastime now. Before 2000 it was both Dow and NASDAQ. After the tech bust, NASDAQ featured less in inter office bets and perceived connections with Indian markets. I also remember another occasion when even a shoe shine boy understood, where we are headed tomorrow was more about the DOW than anything else. The perceived connection was thought to be an unstated rule. On occasion when markets took a different turn locally compared to what the DOW was doing, news of decoupling between global and local markets featured in national newspapers and TV channels. There was always a reason why DOW connection worked or weakened at times.

As time passed and both liquidity and number of investors increased, the forecasting rules became simpler, if there is certainty and an up move; it is generally because of local factors. But when uncertainty comes in it’s the DOW. It did not matter what DOW returned in terms of price changes over a month and quarter. What mattered was the daily and weekly volatility in the benchmarks price performance.

There were not many studies I read since 1996, which actually studied correlation between DOW and Sensex or other emerging market indices and whether such comparisons really made sense. Even fundamental analysts historically have taken refuge in this, suggesting upside as a predictable certainty and downside as the DOW effect. The correlations between DOW and Sensex are poor. Rather correlation itself increases and decreases as markets move from greed to fear. At both extremes, the correlations have known to be high. This is why during contagions every market seems to be correlated.

Going a bit deeper into correlations between DOW and Sensex suggest a historical correlation of 0.69, for the last decade it has been at 0.64, the highest correlation has been since 2002 lows at 0.90 which has fallen now to 0.82, if you look at just the last year. I just ran a random check to see if the correlation could just go negative. And here I was at the first attempt, – 0.42 from 26 May 2005 to 19 Oct 2005. I did a similar exercise on another emerging market INDEX, Romanian BETFI. DOW and BETFI suggest a historical correlation of 0.86. DEC 2003 till DEC 2007 saw high correlation values at 0.92. Every equity index was going up in this time, no wonder such high readings you will find in many equity indices when compared to DOW. DEC 2000-2003, the correlation was negative at -0.68. The random random check lead to a negative correlation at – 0.79 from MAR 2001 to OCT 2002.

Correlations are an illusion that we live in, as you can actually draw a cycle of increasing and decreasing correlations between DOW and Sensex. And what use is correlation anyway. Correlation as a trading indicator works miserably with not much back testing validations.

And if we just extend the relationship to DOW and DOLLAR, which have been to be strongly linked, a strong dollar and positive DOW move together. Even in this pair, the correlations between DOW and Dollar can go awry, cyclically, positive correlation today and negative tomorrow. It just does not work. Once you identify that the correlation is increasing you know the assets are in sync and vice versa. It is like the classic outperformance underperformance Intermarket cycles we have talked about. There will always be a period DOW will outperform Sensex and a period when it will underperform. Just to look at one side of the cycle is extrapolation and ignoring the other side, calling it decoupling, is human.

Dow is our psychological alibi that we use to explain market vagaries. There is no other way you can explain why if the problem is in America, why did China, Russia, India and the world fall more than the DOW. Of course there will be some explanation for this too. But then how quantifiable is it? We at Orpheus believe that emerging markets are better indicators and lead the DOW. India formed the primary low on 21 SEP 2001 months before the 08 OCT low of DOW in 2002. Indian and Chinese Indices may have lagged at the current top, topping after the 11 OCT 2007 high in DOW, but emerging markets like Romania had topped as early as 24 July 2007. This is why DOW psychology remains flawed and OCT low might have more to do with NIKKEI than DOW.

Author: Mukul PAL | Date: 03 October 2008 | Comments (0)

Categories: Triangular Psychology

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We have an index of phone calls at Orpheus. This is an internal sentiment index that we use. The more the calls we receive in a certain week, the stronger the market sentiment. The week that went started with frantic calls regarding the market volatility. “I am long on the market after markets fell 10%, but they don’t seem to stop falling, and now DOW is down too, what should I do?” Another query was, “When will this fall stop. How low can it go?” Another one involved Fannie Mae, Freddie Mac, and Merrill. “What was their future?” Another was regarding short selling ban and how will it modify market behavior? “What else will the regulator do? Open interest has increased in the market, what does it mean? I am still in doubt regarding the bottom. Does doubt about a bottom make it a better bottom?” Of course once in a while we also have the regular confessions regarding leverage and need for vacations and detachment. Markets do take a toll on human psyche and more the emotional maturity better it gets for the investor, trader or speculator.

On the first impression, the frantic call index spiking near panic lows, or capitulation bottoms might look like a strange phenomenon. But a deeper thought and you can start seeing a cycle. We at Orpheus consciously monitor market sentiment. The need to understand sentiment is so strong that whenever we conduct a conference with more than 50-100 people, we do a survey. We did one in Dec 2006, weeks before Romania was to enter the European Union. I raised my hand and asked the large group, how many think markets will become half from here. Not even one hand rose. Jan 2007 saw a collapse of 30% after Romanians celebrated the EU entry and went across the Hungarian border to have coffee without being asked for visa or passport details.

On another occasion in 2007, the same question saw another hand raised along with mine. This time it was head research of an Institutional brokerage company. But we were still in minority, two loners who believed markets can halve in value. Market sentiment is like this, lonely at tops and overwhelming at bottoms. Tops we are kings and bottoms scared prisoners of war, searching for survival trenches to hide in. Capitulations are chaotic while euphoric up moves are celebrations. Tops are when we celebrate and dine with our broker and bottoms are when we fire and sue him. This is the reason the frantic call sentiment Index never spikes at a market top. It is only after markets start falling that the bells start ringing. This is human nature. We pay more for Put options in a market collapse, than we pay for calls in a euphoric rise. Fear remains a stronger motivator than greed.

This is why capitulations can be measured easily compared to euphoric tops. There are also more signals near a bottom than there are exhaustion signs at a top. Above this price rockets can push up higher, but market has a limit to where it can fall to, 50%, 60%, 90% are clear limits on the downside. But upside is technically unlimited, till the moon. There are of course other problems linked with capitulations. Even if we hit or identify a capitulation bottom, prices take more time to rise than to fall. We take more time to build than we take to destroy. We move from margin lending schemes at market tops to banning short sales at lows. There is a complete history of short sale bans and revokes.

The proponents of globalization have also contributed to this capitulation. They just made it global. There are cycles of liberalization and protectionism. We open up and build walls cyclically. Globalization brought free trade, economic growth, and consumerism. Along with all this came speculation and global capitulation where contagions happen together around the world. We talked about one such impending capitulation in The October low. Global contagions and capitulations have group power. When many countries fall at the same time, it creates a stronger sentiment than what a single market collapse would have evoked. Group power hence has more signal power. If we have 10 sectors in the market and all of them are in gear, that’s just the turnaround signal one needs, everything falling and negative at the same time. What happened now was a global contagion. Year to date, Russia is down 50%, Shanghai composite is down 60%, Brazil BVSP and Indian Sensex are down 30%. And along with this if you hear about bankruptcies and bailouts, the panic is bound to be global.

Capitulation cycles can also be linked with simplicity cycles. Markets wake up and ask, “Why we made it all so complex?” There is a strong need to simplify things again. The need for affiliation increases and need for achievement decreases. It is a clear move from the conscious to the subconscious, and introspection. Market knowledge also moves from short term to long term memory. The bigger the crisis, the deeper it gets into market memory. Capitulation is like grieving and mourning. It is a five stage process, anger and intense emotion, denial, guilt, depression and sorrow and finally acceptance.

Sentiment in terms of news also reaches historic proportions when market hits capitulation lows. The bulls thank the Federal Reserve while the bears blame and curse the bailouts. We are in historic times and such high number of capitulations for us may make the stock study redundant, but as a panic extreme, such extreme sentiments still favors potential impending bottoms rather than continued precipitating declines. We need to look at time cycles more to understand whether the capitulation low happened already or is it coming in October? A smarter investor, on the other hand would wonder “What Capitulation?” His green stocks like Vestas Wind, ITT Corp, First Solar are still positive for the year.

Author: Mukul PAL | Date: 22 September 2008 | Comments (0)

Categories: Triangular Psychology

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Information paralysis can be resolved by sentiment indicators which can not only predict but also time market turns.

These two generic sounding terms—diffusion and sentiment—are going to redefine the forecasting business in times ahead. Diffusion might sound familiar to economists as it’s also an econometric technique. But omnipresent sentiment measurement or sentiment indices are not only unpopular but also under-researched. In emerging markets like India and China, they don’t even exist. Internationally, there is not a single book available on the subject. And a web search on sentiment will take you to poetry.

This reminds me of the scene from Asimov’s screen adaptation I, Robot where Del Spooner (Will Smith) asks Dr Alfred Lanning’s (James Cromwell) hologram, “What do I see here?” Lanning’s hologram says, “My responses are limited; you have to ask the right question.” So even if you have the right question, the available answer may be insufficient. It is this insufficiency researchers are struggling with to come with the right forecast.

Information in itself has failed us, as stock prices react to so many factors that even regional fundamental analysts have started looking at the movement of the Dow Jones to gauge market trends. Not very many can disengage from international events and talk about markets or assets on a standalone basis. It’s a clear case of information paralysis. Less is not enough and more is overwhelming. And web searches really don’t help further the search of what really works or how to see through this clutter. Web search is a clutter where ‘loss’ is about weight not about finance, history is not about economics as in econohistory, valuations are about data not about fractals. The search engine’s responses are limited.

It was to see through this chaos that sentiment and diffusion indicators were first designed in 1960s. Are questions on diffusion and sentiment indicators the right ones? This question was partially answered by a client of ours, a national bridge champion, “This 80-20 theory is perfect–if most of the people do one thing, you do the opposite.” Conventional logic might make you laugh at this, but the champion is an intermediate term investor. He is always looking around for sentiment cues from newspapers, big bank securities’ company recommendations, local economic news, international updates etc. After that he gauges the sentiment, which side is heavier, the positive or the negative side. I don’t know how he measures it in his mind, but he surprises us with his uncanny sentiment indicator. It works. He is a good pattern recogniser, a contrarian and this he mixes with a sentiment study.

Diffusion indices are built in the same way. These are survey indicators. Talk to 100 experts and take their opinion for the day. If 80 per cent are on the positive side, we have reached a top and vice versa. Technical expert Martin Pring says, “Sentiment observations are as valid for intermediate term (multi-week) peaks and troughs as they are for primary ones (multi months).” The difference is normally of degree. At an intermediate term low, for example, significant problems are perceived, but at a primary market low, the problems often seem insurmountable. In some respects, Pring adds, “The worse the problem, the more significant the bottom.” He even clarifies that though sentiment indicators work well, it is best to monitor several sentiment indicators simultaneously.

The Advisors’ Sentiment Report has been one of the leading sentiment indicators constructed by Investors Intelligence since 1963. The indicator has a consistent record for predicting the major market turning points. The report studies over a hundred independent market newsletters and assesses each author’s current stance on the market: bullish, bearish or correction. Current readings are put into context against historic precedents. Signals generally arrive when you need them, near important market tops and bottoms.

Conventionally, the best time thought to be long on the market is when most advisors were bullish. This has proved to be far from the case; a majority of advisors and commentators were almost always wrong at market turning points. Quite simply, professional advisors are just as susceptible to market emotions as individual investors. They become far too greedy at the top of trends and far too fearful near the bottom. The contrary indicator only works at extremes. A large part of the time the Advisor’s Sentiment report readings remain neutral ie 45 per cent bulls, 35 per cent bears and 20 per cent neutral. Advisors are only wrong when you get too many of them to start thinking the same thing. Back in October 2002, there were many more bearish than bullish advisors. Historically, this has always been a good time to start thinking about buying the market. Investors would clearly find it more profitable, then, to take a position contrary to the advisory service industry. But then as we said earlier, advisors as a group invariably go wrong.

There are other sentiment reports published in the US like the Bullish Consensus newsletter by Market Vane, which has been around since 1964, well before contrarianism was really written about. There are a host of other indicators like specialist/public ratio ie smart money against not so smart money. Then there is the short interest ratio, inside sell/buy ratio, mutual fund cash/asset ratio, margin debt trends, put/call ratios, inverted dividend yield momentum and volatility indicators.

So, on one side we have sentiment readings and survey findings and on the other hand, experts who fight about lack of information or its excess. Very few of them ask, “Why do you need information anyway?” Studying sentiment is fun. It teaches you about social behaviour, mass psychology, error-prone humans, overestimation of skills, biases, overconfidence and above all herding.

“This time it’s different,” gets a large number of search results. We keep fighting for intellectual supremacy while the market needs a simple study of sentiment to see through the chaos and layers of leverage, which can end your investment life. Investors come and go. Some never came after the 2000 crash and some got burnt in small dips in May 2006 and July 2007. Nobody looks for them and writes about them. And they never come back to the market; not because the market is not a great place to be, but because to survive the market till you die and pass the art of investment to the next generation needs more than information access. It needs the ability to understand market sentiment and ask the right question.

Author: Mukul PAL | Date: 09 October 2007 | Comments (0)

Categories: Triangular Psychology

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Humans are Loss averse. And the individual, corporate and society which understand it thrive despite odds.

“How did this stuff ever get published?” was what traditional economists asked when behavioural economists observed that human beings were loss averse. This aversion is at the heart of human psychology and asset pricing. And if professors are fighting over academic leadership over the subject you can understand why the only “loss” Google search can handle today is that of “weight”. The psychology of a weight loss is positive and motivational unlike the psychology of a monetary loss, which can be pretty depressing. But despite all negativity around the subject understanding loss aversion is at the heart of an investment strategy and even being a successful money manager.

Loss aversion can explain why a price “bid” on or off a trading screen is always lower than “ask” prices. It’s not just because sellers always ask for a higher price than what the buyers can pay but because people attach more pain with a loss of “x” than the pleasure they experience with a gain of “x”. In other words people place more value on giving up an item than on receiving it. Giving up is tougher, more valuable and hence a perceived loss.

So it is not the reality of loss that matters but the perception. And propensity to be loss averse is somewhere connected to a real loss. The more one tries to avoid it, the more it grips you. We have seen nations going to over-extended wars until miserable failures, owing to loss aversion. And loss aversion combined with inability to admit or learn from mistakes can only complicate investment decisions, delaying them till they are of no use, as in a capitulation.

The psychology of a loss works against market timing, and clearly explains why masses cycle from complacency to panic. It also explains why entrepreneurs are contrarians, why we are uncomfortable with geographical risks (Indians trading on the Pakistan stock exchange), why very few of us marry foreigners, why very few intra-day traders make profits consistently, why volatility as an index derives its strength from panic, why our over-trading is an extension of loss aversion and why volume rises when the market goes up and vice versa.

Eric J Johnson, Simon Gächter and Andreas Herrmann, professors at University of Nottingham found some interesting patterns linking loss aversion with various parameters like, age, income gender, education etc. Age seems to be an important moderator of loss aversion. The older we get the more loss averse we are. Gender is an insignificant predictor for loss aversion. So being a woman trader or investor has no intrinsic disadvantage. The study concluded that loss aversion is not a constant. Rather a substantial amount of loss aversion can be explained by the decision maker’s knowledge of the attribute and the attribute’s importance to the decision-maker.

Antonia Bernardo, professor at University of California, Los Angeles, talks about how irrational overconfident behaviour can persist. Information aggregation is poor in groups in which most individuals herd. Shinichi Hirota of Waseda University and Shyam Sunder of Yale talk about how investor decision horizons influence the formation of stock prices. In long-horizon sessions, where investors collect dividends till maturity, prices converge to the fundamental levels derived from dividends through backward induction. In short-horizon sessions, where investors exit the market by receiving the price (not dividends), price levels become indeterminate as they lose dividend anchors. It’s in this case that investors tend to form their expectations of future prices by future expectations. These reasons are important contributors to the emergence of price bubbles. No wonder aggregate markets look for dividends at bottoms and forget them at market tops.

Building on loss aversion, Ravi Dhar (Yale) and Alok Kumar (University of Texas at Austin) analysed the impact of price trends on trading decisions of more than 40,000 households with accounts at a major discount brokerage house and found that buying and selling decisions of investors in the sample were influenced by short-term (less than three months) price trends. They classified investor heterogeneity in trading based on prior returns into momentum buy, momentum sell, contrarian buy or contrarian sell category. The trading behaviour of all the groups exhibited systematic differences in expectations and behaviour. The study could find support to the commonly held belief that relatively more sophisticated investors exhibit contrarian trading behaviour. And, the contrarian investor segment had the best overall performance and their portfolios exhibit better characteristics in comparison to the momentum investor segment.

It’s easy to be a momentum buyer or seller. There’s nothing easier than riding a trend down or up. Unfortunately, riding a roller coaster has its risks and it is not consistent and healthy for a long-term portfolio. There’s more burn effect. A majority of the economic society does not understand this link in profits, markets, psychology and economics. But a few corporate understand and are already strategizing to be ahead. Merck, for example understands this loss aversion and is rewarding scientists for failure. Inability to admit failure leads to inefficiencies in the industry. Despite the Vioxx failure, Merck’s new speed at developing drugs has surprised competitors. Companies are also questioning the fake shareholder power connected with momentum investors with average time durations of ownership barely a few months. They push companies to beat estimates unmindful of the company’s long-term strategy.

The observations and questions we have raised here have a bearing on where we will head tomorrow. When a society becomes loss averse, it looks for a fast buck, looks for more credit driven speculation than real investments, ownership horizons keep getting shorter and loss aversion reaches contagion extremes, as majority sits on the edge ready to exit with the gain. It’s when we reach there, its time for a painful restructuring. Developed markets may still get you 33 cents per dollar claimed after you sue your broker. But developing markets where legislation itself is weak, we are eons away from suing any Dalal Street broker. And both the pain and loss is for us to keep. The faster we understand the psychology of a loss, the better it is for us and for the market.

Author: Mukul PAL | Date: 10 September 2007 | Comments (0)

Categories: Triangular Psychology

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It may appear funny to use the hemline indicator to predict stock prices, but as an indicator it makes money.

When we first read about the hemline indicator, it seemed like a funny joke. A market going up and down with the length of skirts was a strange idea of an economic indicator. Ralph Rotnem was a Harvard graduate and he created the indicator after seeing an uncanny pattern, which kept reappearing.

Because skirt lengths have limits (the floor and upper high respectively), the reaching of the limit implies the concurrence of an extreme positive or negative mood. The social mood was linked with stock market expression.

Working from Europe helped us relate to this indicator with conspicuous clarity. The skirt lengths of women around have witnessed a sharp decrease over the last 24 months.

And even from an extremely open mind, December did not seem that warm, despite all the talk about warm winters. We really were sure that there was not much further north, the skirt could travel. A little more high would mean a beach like scenario. At Christmas parties the debate was hot, and speculations were ripe, and we all were waiting for the desired results.

Well fortunately for us, the stock markets turned down. This diverted our attention to more important stock portfolios away from skirt lengths. The hemline indicator had worked yet again. Strange but transcribing this social mood indicator to other emerging markets was not easy.

In India the dress sense is conservative. How could a pop culture indicator be extended to Indian markets? There must be a way to find out what women in India were expressing, as the stock markets headed up. If only they wore skirts, trading in global stock markets would be as easy as sitting in a park taking down notes, diligently for months. And when we hit an extreme, it’s ‘Sell’.

We express social moods in many ways. When we are happy, then along with skirts or business suits, we also buy cars, listen to vibrant music and see a lot of films. A social behaviour expert could have predicted the big bull market in India after seeing just a couple of Bollywood films. A majority of Indian films had themes of love, dancing around trees and were overall a celebration of life.

This was an expression of socially positive mood and consequently a positive time for stock markets. HBO’s Sex and the City got a celebrity status during such times. After all, Carrie Bradshaw, despite all her knowledge about good sex was looking for love and finally did settle down with Mr Big, a similar theme over occident and Asian cultures in similar time periods.

Human emotions are rhythmical and have wave nature. And these waves are hypothesised to govern all human activities including business, politics and pleasure. When mood trends up, people buy stocks, just like they buy clothes, film tickets, jewellery and clothes. And when the social mood trends down, the broad consumption pattern flags and people don’t buy stocks, they sell.

Robert Prechter has illustrated this concept of social behaviour in his two seminal books on ‘Socionomics’.

He talks about polarity of behaviour. And how humans oscillate between positive and negative moods i.e. between concord and discord, inclusion and exclusion, forbearance and anger, confidence and fear, embrace and avoidance of effort, practical and magical thinking, constructiveness and destructiveness, desiring power over nature and over people, all of which has a consequent effect on markets trending up or down.

Just like the hemline indicator, there is also a skyscraper effect. The higher up we go the sky, the more prosperous we are. And the more prosperous we are, the more near a top we reach. A study of the tallest buildings of the world has historically given accurate signals of intermediate and primary degree tops.

For example the World Trade Centre of 1973 marked the Dow 1000 top. You can look at the Burj Dubai skyscraper timing. The first press release on their site is dated March 2005. The Dubai stock Index peaked months after in November 2005.

The Index is down 62 per cent from the top. Some might call it strange coincidence, but this happens again and again, a historical characteristic associated with skyscrapers. “Let’s make the tallest building”, is associated with a prosperity high. And after prosperity high comes a fall.

Men desire change, or at least bring it about, even when it appears superficially. For example adversity eventually breeds a desire to take charge and responsibility, achieve and succeed, while prosperity eventually breeds irresponsibility, complacency and sloth. Events are perceived as turning points for mankind.

This is conventional, cause and effect relationship. The very reason it does not work. Turning points are generally the opposite as each positive point is a step towards negativity. And each negative point is a step towards positivity. Men produce more goods and services when the dominant social mood is positive.

The reason for the lag between the mood (tracked by stock market) and the result is that people take time to put their new found energy to work. And then reap the fruits of its employment. Plot depressions, recession and economic booms and you see the correlation work.

Prechter has even gone ahead and plotted music as a social expression. How the music we like expressed the social mood of the society. A recent work also connects our preferences for cars. As we go up in stock markets our colour preferences are black, white and red and angular straight cars, remember the white Ambassador? And as our preferences change to transition colours like grey and silver moving to brown and green and rounded cars, we as a society are becoming more negative.

So when you see a green ‘Swift’ on the road, you should be sure that an intermediate top is here. The car is less angular more rounded and it’s green, then the negative social expression has started. We humans see things more rounded as we become negative as a society.

We can afford to be sharp when we go up, but as we go down, smoothing the edges becomes imperative, be it cars or clothes or shoes, rounding just gets in. It has also to do with our ability to visualise. We can not see inversions like inverted yield curves or an inverted picture.

There are a host of trend studies about when we like ghost movies and when we appreciate animation. Why having the hamburger cheapest in Tokyo is not a coincidence? Why making more babies is a positive social mood? And being single or an ageing society comes after a society undergoes negativity in social mood?

As the future is going to be socially negative and these are times we as a society don’t enjoy celebration of love but big screen sex and sirens.

Markets lead events and events are caused by the social mood. And social mood has a mathematical Fibonacci relationship linked with it. Ask an open ended question to a group of 100 people, the answer will most likely be a 62/38 polarity.

And if this still does not hit you, remember your next boss might just be a woman. Women do better in a socially falling transition. And if she drives a green ‘Swift’ and wears a skirt, you might just have got your trade signal.

Author: Mukul PAL | Date: 02 April 2007 | Comments (0)

Categories: Triangular Psychology

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