Reasons to Expect More Upside

I have not concluded definitively how much longer the market can be expected to be strong. From the very conservative T presented in the chart above, a continuation of the rally over six more trading sessions is projected-- so that is how far out in time my call extends.


This chart is of the Russell 3000 advance-decline line, a refreshing change from the NYSE advance-decline line that is also broad enough to reflect "the market" as a whole. It has made a new high. In short, internals support this rally.

Lessons in Sentiment

There was a powerful uptrend in the stock market from September 2010 to February 2011, interrupted by one correction in November. I have anecdotally observed that 1344 exceeded the price target that many were expecting before another correction would ensue.

Throughout much of this trend, as early as December when the S&P 500 was in the low 1200s, high levels of bullishness, measured by investor polls and option put/call ratios, were often quoted as a reason to expect a 5% or greater correction. I was also guilty of these forecasts, embarrassingly early.

What have I learned? For anticipating market turning points, extreme bullish or bearishness is only part of the sentiment picture. This sentiment sets the conditions for what I am hypothesizing is a better sentiment-based timing tool—that is, capitulation. Synonymous with surrender, this is the preferred term in finance for two similar behaviors. First, capitulation is when investors who have held on to positions during a bear market with the tenet that “prices always go back up,” finally cannot endure the pain of seeing the value of their accounts drop, and decide to sell. This is an event that defines a primary trend. Smaller trends and turning points can be affected by the second type of capitulation, in which the callers of a bottom in a bear market give up and turn bearish, or the callers of a top in a bull market give up and turn bullish.

It is not extreme sentiment that will cause the market to turn, but rather, capitulation. One would expect capitulation to occur in an environment of extreme sentiment. As long as there is a significant enough group of individuals calling for a top, there may be 1) short sellers and 2) buyers on the sideline, not wanting to enter at a top. A top occurs once there are no buyers left—investors on the sidelines can still buy and shorts must buy to cover positions. These two groups must be converted before the actual top is printed.

A great and sad irony results from these phenomena. If capitulation is a necessary condition for a top or a bottom, then the market will not turn until it occurs. Think about that. As long as a group of individuals hold on to their belief that the markets will turn, the markets won’t turn. The majority’s conviction must be broken because this conversion, ipso facto, caps off the trend.

Sometimes, capitulation is identifiable by major spikes in volume coupled with parabolic moves in what are called blow-off tops and panic bottoms. There are no polls set to capture this type of surrender, per se. What one must identify is the conversion of bulls to bear or of bears to bulls, not the absolute level of each. To do so, one must scout for viable anecdotal evidence. Perhaps technical tools can be devised to measure this conversion.

In summary, in an environment of extreme sentiment, one must look and wait for capitulation in order to better time a turning point. For this to happen, I hypothesize that the majority of countertrend forecasters or traders, by necessity, have to convert. Until they do so, an established trend will continue.

Post-Script

It is now clear that the reaction ended today at the 1305 level. Upon closer inspection of Box A in the previous chart, it was actually 16 points, far enough from the approximation of 20 points to be of consequence. An equal reaction in Box B would have yielded a 1304 target. It pays to be precise. This outcome demonstrates how accurate a simple box analysis can be.

Retest 1300

Box A was the previous reaction of around 20 points. A similar reaction, projected by box B, would return SPX to 1300, a retest of the breakout level. 1302 is also the 50% retracement of the move from 1284 to 1320.

Cognitive Behavioral Analysis of Financial Markets

Note: the content of this post was published in the Technically Speaking enewsletter in early March of 2011. A prior draft, which was much cruder conceptually, appeared in this blog in 2010.

In this post, I explore investor psychology and investment themes within a framework borrowed from the branch of psychology known as cognitive-behavioral theory. Studies have found cognitive-behavioral therapy to be one of the most effective forms of therapy. Its concepts and tools are extremely powerful and I believe that they are just as applicable for investing.

In the context of financial markets, cognition refers to the mental representation and attitude towards information, fundamental or otherwise. (The “mental representation of and attitude towards” information can be abbreviated to the “perception of” information.) Stated simply, cognition deals with how an investor interprets new information, namely, whether it is fundamentally positive or negative, and the investor’s attitude towards it, namely, whether the market has overvalued, undervalued, or fully valued its significance. Over/under/fully valued is equivalent to being over/under/fully discounted. These perceptions translate to three possible behaviors, choosing to buy, sell, or hold. A change in price has the unique quality of being a consequence of behavior, a stimulus of behavior, and information. Investors learn buying and selling behavior through these various inputs.

These principles and dynamics can be summarized by the following definition:

• Cognitive-behavioral analysis – asset prices are governed by learned investor behavior, and the mental representation of and attitude towards information

Compare this with the traditional postulates of financial markets:

• Fundamental analysis – asset prices reflect the present value of future cash flows discounted by a required rate of return
• Technical analysis – prices reflect the balance of investor supply and demand for a given asset

There is certainly overlap among these types of analysis. One of them need not prove to be “right” at the expense of the others; rather, they are supplementary approaches to the study of a complex subject. An advantage to multiple approaches is that each provides alternative focuses, interpretations, and at times, novel insights.

Bubbles are a classic example of a market phenomenon that can be concisely explained by the principles of cognitive-behavioral analysis. New era thinking and investor exuberance (cognition), and rising prices (behavior and information) all participate in a self-reinforcing cycle. That explanation satisfies the conditions of the theory. Note that irrationality, in this framework, is not an element of bubbles. (If anything, astute investors who correctly identify a bubble can be categorized as irrational if they chose to short sell such a market.) The new era thinking, even if fundamentally unsound, is in essence a rationalization of price behavior. This is an important point because a bubble does not burst when investors turn from “irrational to rational,” it bursts when their perception changes.

Recall that the “mental representation and attitude towards” information can be abbreviated to the “perception of” information. A popularly shared and enduring perception, like new era thinking, is an investment theme. In recent history, an economic news release falling below expectations has often propelled markets higher because it has signified an extension of the loose monetary policy that is fueling the bull market, a dominant investment theme. In this case, the disappointing unemployment release is mentally represented as fundamentally positive; the attitude towards it is that the market has not fully discounted the extension of quantitative easing; the end result is a bidding up of prices. In analyzing such information, fundamentals are too ambiguous and too focused on a longer time frame. Technicals do recognize the relationship between news releases and price action, but they fail to give due prevalence to the investment theme.

If in market phases as different as the dot.com bubble and a bull market driven by monetary policy investors are operating by the same cognitive-behavioral principles, then one can induce that investor psychology is a prevalent force throughout all market cycles! As technicians have always stated, human behavior is an essential element of financial markets.

Now that I have broadly defined cognitive-behavioral analysis, I want to provide an application that aptly that falls under its conceptual framework.

Paradigm Shifts

A paradigm shift, also referred to as a gestalt shift, is a sudden, revolutionary change in a dominant perception. Both of these interchangeable terms are also taken from psychology. Paradigm comes from Greek for “pattern”, and gestalt is a German word meaning “shape” or “form.” Studies in gestalt psychology were precursors of cognitive theory. A commonly used analogy for a paradigm shift is that of the perception of a three-dimensional drawing:



In the rectangular prism above, rectangle ABCD can appear to be anterior if one’s vision focuses on it; however, a focus on rectangle EFGH can suddenly shift the viewer’s perception, making it anterior and rectangle ABCD posterior.

In financial markets, the sudden, revolutionary change in a dominant perception can result in a change in a price trend. The cousin of this concept is the catalyst. The catalyst, however, is a fundamental event, and may or may not result in a new trend. The difference subtly captured by cognitive-behavioral analysis is that the trend reversal is primarily a psychological event caused by a change (shift) in investor perception (paradigm).

In Inside the House of Money, a series of interviews with global macro investors, an anonymous currency trader elaborates on the subject:

"What signals a great macro trade?

I’m looking for signs of a gestalt shift in the markets, where all of a sudden, the market’s view on something instantly changes…

A gestalt shift usually comes after volatility gets pumped up because everyone is out there buying insurance. When people are buying options to protect positions, it means they have an underlying position they’re nervous about.

The big trades in macro are when the market is going to reprice a view or shift to a whole different concept. I spend a lot of time looking at where market sentiment is in hopes of finding the next shift."

Bernard Baruch also makes note of a paradigm shift, referring to it as a break in the “continuity of thought,” in his autobiographical, Baruch: My Own Story, published in 1957.

"A bull market, for example, will be sweeping along and then something will happen—trivial or important—and first one man will sell and then others will sell and the continuity of thought toward higher prices is broken.
'Continuity of thought'— what a wonderful expression that is."

Baruch continues, proving an example:

"The first time I heard [the expression] was while I was operating in steel stock which J.P. Morgan was trying to accumulate. The general market was on the rise. Then, while these operations were going on, the stock of Rock Island broke. At the time I happened to be with Middleton Burrill, who remarked, "That collapse is going to break the continuity of bullish thought." I had never heard the expression before, but I saw at once that Burrill was right and even though Steel was being supported by the Morgans, I sold and took my profits."

Arguably, a paradigm shift abruptly ended the bear market of 2007-2009. This shift was: the financial system will not utterly collapse. On March 10th, 2009, the day after the closing low of the bear market, Citigroup CEO Vikram Pandit delivered a letter to employees stating that he expected the bank to have its first profitable quarter since 2007. This release caused the paradigm shift. The S&P 500 closed 6.4% higher that day and ended up 10.7% for the week.

The 2009-present bull market commenced three months after the Central Bank first established a target federal funds rate of between 0 and .25%. This policy has been a major fundamental driver for the bull market. Note, however, that the Fed action did not serve as a catalyst! Prior to March 2009, investors took advantage of rallies caused by loosening monetary policy and related programs to unload on stocks. It was the comment by Citi’s CEO that restored investor confidence. The day of the announcement, I remember my father ominously stating, “Investor psychology has changed.”

The first leg of the bull market, spanning from March to May of 2009 can be framed by four events related to the financial system. In fact, the major and minor inflection points of the first leg occurred on these four news releases. Below is a chart in which the events are marked. These pivot points were clear signs that the health of the financial system and quantitative easing was an investment theme dominating market activity.



Cognitive-behavioral analysis implicitly suggests that investors place a thorough research focus on identifying investment themes, which can greatly influence market behavior over an intermediate term. Moreover, the early detection of a paradigm shift can prove valuable. One way to identify themes is to detect which material events or news releases frame market pivot points, as in the example above.

Given the current predominance of Federal Reserve policy over populous thought, a paradigm shift in this theme would probably be significant, to say the least. The chart below is from Google Trends. The y-axis in the upper chart represents the search volume on Google, worldwide, for the keywords “quantitative easing.” The lower chart is of news reference volume. (Please ignore the flags with letters; they represent specific news articles not shown in the figure below.) One can see the degree to which this term has become prevalent.



Conclusion

Cognitive-behavioral analysis is a conceptual framework intended to improve the understanding and predictability of financial markets. This method considers investor perception and behavior paramount in determining price trends. Paradigm shifts, discussed in this article, is one applied concept, but the richness of the field of psychology, established through decades of research, provides various other applications (a topic for future articles).

Just as behavioral finance, which has also inherited conclusive studies and principles from psychology, is now a mature subset of finance, a theory such as cognitive-behavioral analysis can broaden the current theories of finance that are professionally and academically regarded. Such broadening can loosen the strongholds of fundamental analysis, the efficient market hypothesis, and modern portfolio theory in the investment community.