TRADING PSYCHOLOGY
Smart Money
by Scott Brown
Should you develop a personal trading system, one that reflects
your own personality?
A belief persists among investors that a select group
of traders have the inside edge. Some indicators, such as The Commitment
Of Traders Report, try to track the activities of these traders. Some recent
research may shed light on the composition of this group, as well as the
techniques that the Market Wizards use to consistently beat the market.
Once the market participant understands the areas that make a difference,
he can use this knowledge to improve his trading performance.
FIGURE 1: CRUDE OIL, 1990. Trading the markets is a
social phenomenon. Investors are also greatly influenced by mass psychology.
This could explain trendlines of markets in the limelight that have dramatic
shifts in slope. An example is the petroleum futures bubble at the end
of 1990 that was sparked by the Gulf War.
MARKET VOLATILITY
Trading the markets is a social phenomenon. Investors are also greatly
influenced by mass psychology. This could explain trendlines of markets
in the limelight that have dramatic shifts in slope. An excellent example
is the petroleum futures bubble at the end of 1990 that was sparked by
the Gulf War (Figure 1). It could also explain stocks in low-volatility
channels despite favorable earnings, growth and dividends at the end of
bear markets when public interest is low.
EFFICIENT MARKET HYPOTHESIS
Random walk, or efficient market hypothesis (EMH), contends that past,
present and future prices accurately reflect information coming into the
market. Economist Robert Shiller of Yale University is one of the leading
challengers of standard EMH. He emphasizes the role that popular opinion
could play in volatility. Shiller's research indicates there is more volatility
in the market than the Emh model can account for; price may not always
reflect value.
Shiller avers that speculative asset price movements appear to be influenced
by factors other than fundamentals. He cites Richard Roll, who observed
that information about the weather dominates news concerning orange juice
futures. Meanwhile, most price movements in orange juice futures appear
to be unrelated to the weather. Further, the volatility of orange juice
futures is not as high over the weekend when there is an equal amount of
news about the weather as during the week. Stock price volatility from
Tuesdays to the following Thursdays was found to be lower during those
periods when the stock market was closed on Wednesdays, even though it
would seem that just as much information was available.
According to Shiller, EMH researchers themselves have found a number
of small anomalies, as if fashions or fads dominated financial markets.
He cites literature finding that high earnings price ratio stocks are slightly
more profitable than the market (4.4%). Conversely, low earnings price
ratio stocks do slightly worse, so that the stock becomes overpriced. Another
anomaly is the tendency of high book value price ratio stocks to earn more
than the market, with an abnormal return of 4.4% per year. Stocks whose
prices had declined precipitously in the last three years showed an abnormal
return of 6.1% per year over the succeeding three years following the drop.
The notion of market efficiency has been useful over the past few decades.
Shiller emphasizes, however, that the finance profession has carried it
to extremes in that alternative theories based on psychological research
are virtually never discussed in financial journals. He states that some
particular speculative asset price movements appear to primarily reflect
fundamentals, while in other cases volatility may be due to changes in
fashion.
Shiller's studies conclude that the aggregate dividend stream has been
trendlike enough to attribute most of the price variation in the stock
market over the past century to fashions or fads. Most important, he states
that another avenue of research shows that movements in the aggregate stock
market over the past century are almost entirely due to fads or fashions.
This shows that aggregate real-stock price indices have moved more than
the present value of the corresponding real dividend series, the present
value behaving much like a trend through time. Shiller contends that real
stock prices may have fluctuated over the past century with little or no
validating changes in fundamentals.
