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Think, and Think Again, Before You Trade


Clouds on the horizon make it even more crucial to put reason before passion.


"I can calculate the movements of heavenly bodies, but not the madness of men."
- Sir Isaac Newton

Before we talk about the markets, let's spice up this discussion with an experiment conducted by professor Max Bazerman at Harvard.

Bazerman announces a game where a $20 bill is offered for auction – there are two rules to follow.

The first one is that the bids are made in $1 increments. The second rule is that the highest bidder wins the auction (the $20 bill), but the runner-up also has to honor their bid, even though that bidder gets nothing in return. As Bazerman describes it, "The pattern is always the same. The bidding starts out fast and furious until it reaches the $12 to $16 range."

Suddenly, everyone realizes that the idea of winning a $20 bill for less than face value isn't unique to them, and everyone but the two highest bidders drops out of the game. Clearly, up to this point, those students were trying to win the $20 bill for cheap; and now, suddenly, they are vying to not be the runner-up; they are both committed to the strategy of playing to not lose, instead of winning.

Once the price crosses $20, reason dictates that one of them stops and concedes defeat, in the interest of stopping the auction with minimal losses. But the reality is that while it's reasonable, neither one of them wants to be the one to adopt that rational approach; they are both committed to the path that instigates higher bids, which drives the price up and makes the potential loss even higher.

The bidding war led to a record of $204 bid for a $20 bill.

What would you do in Bazerman's auction?

So, it's time for a short quiz: What did you think I was talking about in the Bazerman's experiment?

A. Bazerman is a professor at Minyanville.
B. The US dollar should go higher.
C. Passion can rule reason.

If you said 'C,' give yourself a pat on the back. There are many examples in life when reason is trumped by emotion -- for better or worse. So why should the market be held to a higher standard? In fact, the market is hostage to the same emotions.

"Your reason and your passion are the rudder and the sails of your seafaring soul. If either your sails or your rudder be broken, you can but toss and drift, or else be held at a standstill in mid-seas. For reason, ruling alone, is a force confining; and passion, unattended, is a flame that burns to its own destruction."
- Kahlil Gibran

So, is their anything that can decipher such innate but irrational behavioral traits? Can we get clues from studying market behavior that might give us an advance indication of the market's future direction? I look to various criteria to gauge such clues, including non-confirmation in breadth and market internals, sector-divergences, and oscillators that help determine overbought conditions.

For example, here is a small list of non-confirmations and divergences that I shared in my notes on the Buzz – which preceded significant declines in the past few months.

1. In September we looked at divergences in Semiconductor Index (SMH) and several Nasdaq stocks such as Apple (AAPL), Google (GOOG), and Research in Motion (RIMM), pointing to an "abyss" (See Minyan Mailbag: How Vicious Will Bear Be on Its Last Leg?)

2. On November 5, 2008, Minyanville opined "There might be a bull market somewhere, but this is still a bear market right here." Shortly thereafter, I wrote Should We Be Forgetting About the Low and Instead, Looking Out Below? after noticing the market wasn't reacting to oversold conditions.

3. On January 2, as the market was vaulting toward January highs, banks showed a major divergence. On January 14, this divergence became even more significant in the financials and Transports, and I shared my thoughts in a piece entitled The Emperor Has No Clothes.

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No positions in stocks mentioned.

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