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The Behavioral Trade


Behavioral finance confirms that humans really are "creatures of habit."


"The Fundamentals Haven't Changed?"

The Adoration phase in Equity Culture is over. The psychological history shown in the chart below suggests that markets are a long way from a significant selling Capitulation. At the 2003 market lows, my firm identified an Equiphobia environment when no one wanted to own stocks. Few realized that stocks had bottomed because, "The fundamentals hadn't changed!" But psychology had changed! Iraq was seen as a huge negative in 2003 but now has only a negligible or peripheral focus!

I had suggested that the current market had some psychological similarities to the 2000 stock market top. But this is nothing like the mania of 2000! Though it may be a similar phase on a different order of magnitude. Note that in 2000, the "Fundamentals didn't change" either. They still haven't changed: the Internet and E*commerce turned out to be very viable. Synchronized globalization and the Asian economic acceleration will still occur but that doesn't mean that stock markets can't correct significantly!

The Psychological Phases of the Market

Bubbles are Inevitable and Eventually Result in Rude Burps

Human hubris ensures that bubbles will always form. Bubbles are a conceptual collusion in which all of the market players become rationally convinced of a seemingly unassailable set of stories. Bubbles are never fully recognized when they occur and they are always harshly corrected. And, they are also denied. Why is everyone looking for the low so soon? Investors love to think they understand the market by a preferential fundamental narrative. But, they do not understand the all-important psychologicals. What is the use of psychologicals? They can locate the position of the market. Note the forecast below which my firm published on Sep. 28, 2001. It allowed for an intermediate term rally in 2001 with the caveat that the market had not really bottomed.

The Seven Stages of Bear Market Behavior

Behavioral Trading on the Hourly Scale

The same psychological understanding shown above on a long term time frame can be applied to an Hourly history as shown below. My firm looks for upward gasps in prices to signify minor manias. This diagnosis is confirmed when prices fall sharply from those gasps. The graph below shows the larger degree Adoration extreme as well as the lesser degree Adoration extreme which signaled the end of the first bounce. Traders may wait for the ext minor Liquidation/Capitulation phase, like the one on March 6th, to cover. Thus a psychological analysis can be used to augment your understanding of the market.

Trading the Psychological Phases

How Available are You?

Behavioral finance confirms that humans really are "creatures of habit." Economists call these habits Heuristics. One of these habits is called the "Availability Heuristic" which means that we are attracted to and believe in whatever stories or news seems to be getting the most attention around us. Popular ideas are very "Available." Thus, we believe in them. At stock market extremes, there are a multitude of bullish stories and bullish news. However, these fundamental stories are the poorest indicators precisely at market extremes.

We all like to be right and we like to be on the right side of the market. Investors don't like to change their minds or their mindsets! When we hear the refrain "The fundamentals haven't changed," the psychological translation might be: "We have been so convinced by everything we have heard that our perception of the situation is quite solid and we have no interest in the very uncomfortable process of changing our mind." There is nothing more painful than changing your mind! But eventually, existing but ignored (repressed) stories like subprime seemingly arise and become new negative conceptual leaders. Yes, subprime is only a minor issue (like the carry trade?) but it has metaphorical momentum and can become infectious. It is the rationale for re-pricing risk. More re-pricing please!

Making Friends with Mr. Market

Everyone wants to stake a claim on the market as if it were enemy territory. Why not try to understand the market? Why not try to make friends with it? If you want to understand your wife, your child, your friend, or your relationship with the market, you have to understand and appreciate their psychology. Don't try to beat the market, try to make friends with it. Try to understand that the market is a psychological creature too. Mr. Market is correcting…really. Don't deny him, play along with him!
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