Despite market performance, especially by mega-cap tech companies, economic data suggests trouble ah...
What's Dangerous About the Stock Market Right Now?
07/03/2020 6:00 am EST
While many viewed unemployment, or the Coronavirus, or the slowed GDP, or a myriad of other factors as reasons to believe the market is dangerous, I propose that these four-letter words are more dangerous to your investment account than anything else: NEWS, BIAS and HOPE.
You see, many will turn to the news to determine which direction the market will move. Yet, much research has been done over the last several decades which suggests that news does not have the impact many believe. In fact, the usual way it plays out is that the market makes a move and business media search for the most likely headline they can attach to the move. Not very scientific.
In a 1988 study conducted by Cutler, Poterba, and Summers entitled “What Moves Stock Prices,” they reviewed stock market price action after major economic or other type of news (including major political events) in order to develop a model through which one would be able to predict market moves retrospectively. Yes, you heard me right. They were not even at the stage yet of developing a prospective prediction model.
However, the study concluded that “macroeconomic news . . . explains only about one fifth of the movements in stock market prices.”
They even noted that, “many of the largest market movements in recent years have occurred on days when there were no major news events.” They also concluded that “There is surprisingly small effect [from] big news [of] political developments . . . and international events.” They also suggest that: “The relatively small market responses to such news, along with evidence that large market moves often occur on days without any identifiable major news releases casts doubt on the view that stock price movements are fully explicable by news. . . “
In August 1998, the Atlanta Journal-Constitution published an article by Tom Walker, who conducted his own study of 42 years’ worth of “surprise” news events and the stock market’s corresponding reactions. His conclusion, which will be surprising to most, was that it was exceptionally difficult to identify a connection between market trading and dramatic surprise news. Based upon Walker's study and conclusions, even if you had the news beforehand, you would still not be able to determine the direction of the market only based upon such news.
In 2008, another study was conducted, in which they reviewed more than 90,000 news items relevant to hundreds of stocks over a two-year period. They concluded that large movements in the stocks were NOT linked to any news items: “Most such jumps weren’t directly associated with any news at all, and most news items didn’t cause any jumps.”
External events affect the market only insofar as they are interpreted by the market participants. Yet, such interpretation is guided by the prevalent social mood. Therefore, the important factor to understand is not the social event itself, but, rather, the underlying social mood, which will provide the “spin” to an understanding of that external event (see Landon Whaley’s work on the Fundamental Gravity of Markets).
In fact, even Dennis Gartman had to finally admit that "We have learned that economic news doesn’t matter until it matters . . ."
That truth is that when negative economic news eventually seems to matter, it is simply because it is coincident with the downturn in the market and not the cause of it. To assume otherwise is to retain blinders when the market clearly ignores that negative news as it continues to rally (as we experienced during April and May), and then figuratively taking off the blinders when the market finally turns down.
Yet, many market participants and pundits are much like Mr. Gartman. In fact, they are no different than my children when they would try to time the changing of the light from red to green. They would look at the traffic light and say “now.” And, if it did not change, they would again say “now.” And, this would go on numerous times, depending on how long the light takes to change. When the light finally changed while coinciding with one of their “now’s, they proudly assume that they caught that timing ever so perfectly.
So, when I read pundits repeat reason after reason as to why the market will drop, I view it as akin to my three-year-old child saying “now.” Eventually, the market will turn just like the traffic light will eventually turn and the pundit will react just as proudly as my three-year-old, assuming they caught that timing perfectly. Clearly there is no prescience in their ability to identify the cause of that turn.
Just like my three-year-old did not comprehend that there is something internal to the traffic light that caused the light to change, the pundits do not comprehend that there is something internal to the stock market that will direct it. If this has not been clear to market participants since we struck the bottom to the market in March, then there is nothing more to say.
In a paper entitled “Large Financial Crashes,” published in 1997 in Physica A., a publication of the European Physical Society, the authors, within their conclusions, present a nice summation for what directs the herding principle within financial markets:
Stock markets are fascinating structures with analogies to what is arguably the most complex dynamical system found in natural sciences, i.e., the human mind. Instead of the usual interpretation of the Efficient Market Hypothesis in which traders extract and incorporate consciously (by their action) all information contained in market prices, we propose that the market as a whole can exhibit an emergent behavior not shared by any of its constituents. In other words, we have in mind the process of the emergence of intelligent behavior at a macroscopic scale that individuals at the microscopic scales have no idea of. This process has been discussed in biology for instance in the animal populations such as ant colonies or in connection with the emergence of consciousness.”
So, one has to honestly question if the Coronavirus was simply coincident to a market downturn, rather than a direct cause. It may have been simply another “now” in the game played by my children, especially after the market had been extremely stretched to the upside.
The next dangerous four-letter word is BIAS. Once a bias has been established within the mind of an investor or pundit, it is quite rare to see that person be able to move away from that bias. As Albert Einstein once noted, “Few people are capable of expressing with equanimity opinions which differ from the prejudices of their social environment. Most people are incapable of forming such opinions."
For example, even though the market provided us with a 35% crash back in February and March, recency bias caused most investors and pundits to not only sell near the lows, but it kept them from getting back into the market because they simply knew another crash was going to happen. That crash certainly happened, but it was in the opposite direction.
Yet, if you had read most of the articles on Seeking Alpha during the recent 50% rally in the SPX, all you heard was how the market was about to imminently crash again due to unemployment, or bankruptcies, or the recent spike in Coronavirus infections.
It is time for you to be honest with yourself. Did that rally surprise you? Were you following all the news, pundits and analysis which explained how the next crash was so certain to occur? Did that cause you to be looking down again while the market rallied 50%?
As one of our members recently wrote:
“Stop listening to the market talking heads and scouring the internet for flawed investing advice and learn why the vast majority of individual investors allow themselves to be manipulated into bad trading decisions.”
This brings me to my last, and most dangerous, four-letter word: HOPE.
While many were so certain that the next crash was about to occur, many investors shorted the market during that 50% rally. Were you one of them? Did you have a plan which would cause you to stop out when you realized the initial thesis for your short was wrong? Did you have an objective perspective which told you your initial thesis for your short was wrong? Or, did you ride the short all the way up during that 50% rally because of your “hope” that the next crash was imminent?
Unfortunately, many who shorted only covered when we approached the 3200, at least based upon the put/call ratios I was tracking. This means that, while many began to short the market based upon recency bias, the most dangerous four-letter word in the investment world – hope – kept many in those short positions during one of the strongest rallies in market history.
And, now that most of those short positions have been forced to cover, the market is setting us up for a larger degree pullback over the summer. While it is still possible that the market may make an attempt at the prior all-time high first, it is likely that we will see levels much lower than where we are today before we are ready to attack the 4000+ region.
So, now the questions you have to ask yourself are if you are going to allow the news to direct your investment thesis; if are you going to buy into the common bias or a recency bias about the market; and if are you going to maintain a losing position based upon your hope?
Avi Gilburt is a widely followed Elliott Wave analyst and founder of ElliottWaveTrader.net, a live trading room featuring his analysis on the S&P 500, precious metals, oil & USD, plus a team of analysts covering a range of other markets.
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