Trading on Sentiment

The Power of Minds Over Markets

Richard L. Peterson

• Publisher: Wiley
• Year: 2016
• ISBN:
  9781119163756
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

In his debut book on trading psychology, Inside the Investor's Brain, Rich­ard Peterson demonstrated how managing emotions helps top investors outperform. Now, in Trading on Sentiment, he takes you inside the science of crowd psychol­ogy and demonstrates that not only do price patterns exist, but the most predictable ones are rooted in our shared human nature.

Peterson's team developed text analysis engines to mine data - topics, beliefs, and emotions - from social media. Based on that data, they put together a market-neutral social media-based hedge fund that beat the S&P 500 by more than twenty-four percent—through the 2008 financial crisis. In this groundbreaking guide, he shows you how they did it and why it worked. Applying algorithms to so­cial media data opened up an unprecedented world of insight into the elusive patterns of investor sentiment driving repeating market moves. Inside, you gain a privi­leged look at the media content that moves investors, along with time-tested techniques to make the smart moves—even when it doesn't feel right. This book digs underneath technicals and fundamentals to explain the primary mover of market prices - the global information flow and how investors react to it. It provides the expert guidance you need to develop a competitive edge, manage risk, and overcome our sometimes-flawed human nature. Learn how traders are using sentiment analysis and statistical tools to extract value from media data in order to:

• Foresee important price moves using an understanding of how investors process news.
• Make more profitable investment decisions by identifying when prices are trending, when trends are turning, and when sharp market moves are likely to reverse.
• Use media sentiment to improve value and momentum investing returns.
• Avoid the pitfalls of unique price patterns found in commodities, currencies, and during speculative bubbles

Trading on Sentiment deepens your understanding of markets and supplies you with the tools and techniques to beat global markets— whether they're going up, down, or sideways.

Part One
Foundations

Chapter 1
Perception and the Brain

What we are betting on is that the perceived risk exceeds the actual risk. That's fundamental to the theory of everything we do.

—Wilbur Ross

Hurricane Katrina struck the U.S. Gulf Coast in 2005, and it was followed by another category 5 hurricane—Hurricane Rita—several weeks later. Following Katrina's impact, the media were saturated with tragic images of submerged residential neighborhoods. Videos cycled on major news networks of flooding victims stranded on their rooftops. They waved to news helicopters for help against a backdrop of dead bodies floating in the murky brown floodwaters. Katrina was the most expensive natural disaster in U.S. history with total property damage estimated at $108 billion (in 2005 USD). At least 1,833 people died in Hurricane Katrina and the subsequent floods. Insurers were liable for billions of dollars in damage claims, and they raised their premiums over 50 percent in each of the following two years.

There was an increasing perception that category 5 hurricanes would devastate the Gulf Coast more frequently. An influential scientific study published in 2005 identified an acceleration in the rate of powerful hurricanes in the Atlantic Ocean. Al Gore's movie, An Inconvenient Truth, about the catastrophic environmental risks of global warming, was released shortly after the hurricanes struck. The devastating 2005 Atlantic hurricane season appeared to imply that worst-case scenarios were coming to fruition even faster than predicted.

Savvy investors, especially reinsurers, smelled opportunity in the heightened risk perceptions. Both Warren Buffett's Berkshire Hathaway and billionaire investor Wilbur Ross poured money into Gulf Coast reinsurance enterprises. In a Wall Street Journal interview, Ross explained such investments by stating, “What we are betting on is that the perceived risk exceeds the actual risk. That's fundamental to the theory of everything we do.”¹

Fear, by definition, is an emotional response to the perception of danger. Fear arises when humans anticipate threat, and the unpleasant feelings associated with fear motivate action to avoid those threats and eliminate the uncomfortable feelings (e.g., urgently buying insurance against the next storm). Savvy investors locate such fear-driven opportunities and exploit them.

It's worth considering what investors fear. They fear zombie investments that never live up to their potential. They fear fat fingers, hackers, and ghosts in the machinery of Wall Street that can bankrupt them in milliseconds. They fear debt, incompetent governance, and terrorist attacks. There are too many risks to track on Wall Street (and in life). And while investors cannot understand or anticipate every risk, they can strive to understand when others are going astray in their assessments of such risks.

This book examines the market price patterns created by investor psychology. Prices typically don't respond in an obvious way. Sometimes they respond to events within milliseconds, other times over days, and sometimes not at all. Sometimes prices fluctuate and sometimes a trend is born.

Price patterns are a result of collective investor buying and selling in response to new information. That dry description doesn't adequately embody the euphoria, anguish, and boredom behind the real-world market events that drive manias, panics, and price trends. This book's goal is to demonstrate how information flow in the media-through effects on investor psychology such as the increased risk perceptions following a hurricane-creates opportunities for investors.

A Long Estrangement

When I went to financial economist training school, I was taught the “Prime Directive”:

Explain asset prices by rational models. Only if all attempts fail, resort to irrational investor behavior.

—Mark Rubinstein, from “Rational Markets: Yes or No? The Affirmative Case” (2001)²

The academic disciplines of psychology and economics were largely estranged from the Second World War through the early 21st century, but it was not always thus. Josef De La Vega's book Confusion De Confusiones was the first to describe the market microstructure of a stock market—the Amsterdam exchange—and it is also the first historical commentary on the emotions of market speculators. De La Vega notes that the Amsterdam bourse was dominated by the perpetual conflict between the liefhebbers (“lifters-up”) who were “scared of nothing” and the contremines (“underminers”) who were “completely ruled by fear, trepidation, and nervousness.”³ In ensuing centuries, such influential economists as David Hume (1780) analyzed the “motivating passions” that drive human economic behavior.⁴ In 1939, John Maynard Keynes famously speculated that “animal spirits” drive economic growth.⁵

Despite these early references to psychological forces driving stock traders and economic activity, another field—physics—served as the inspiration for most post–World War II academic economists. Physicists were successfully applying complex mathematics to model natural phenomena, with the atomic bomb being the most dramatic example of the advances in that field. Emulating physicists, economists crafted overarching theories and employed complex mathematics to model economic processes. In order to streamline assumptions, economists adopted a view of human judgment and behavior as being purely rational. As Mark Rubinstein noted in the epigraph, many (if not most) academic economists consider this assumption the default position in theoretical models.

The assumption of the rational investor is generally quite useful in modeling, but it misses many important exceptions. As Peter L. Bernstein, a money manager and the first editor of The Journal of Portfolio Management, put it, “Indeed, as civilization has pushed forward, nature's vagaries have mattered less and the decisions of people have mattered more.”⁶ Overlooking the complexities and irrational nuances of human behavior has become a significant impediment to the advancement of academic economics.

Like economics, psychology was similarly beholden to theoretical orthodoxies in the latter half of the 20th century. Many psychologists worked based on the assumptions of Freudian theory and other unempirical dogmas. Behaviorists were an exception to this empirical drought, and research by experimental psychologists such as B. F. Skinner and Ivan Pavlov captured the public imagination. Their work demonstrated that human behavior could be systematically and predictably irrational, and it could be shaped with incentives such as rewards and punishments.

Rather than working on a grand unified theory of behavior, psychologists took a piecemeal approach to understanding human nature. They crafted independent theories—often based on experimental results—to explain individual idiosyncrasies or to solve specific clinical problems (such as how to relieve paralyzing anxiety). Meanwhile in medicine, research on pharmaceuticals identified chemical compounds—both recreational and therapeutic—that uniquely altered mood, judgment, and even financial risk taking. Based on work by empirical psychologists and psychopharmacologists, evidence-based treatments are currently deployed in the treatmen...

Table of contents

• Cover
• Title Page
• Copyright
• Table of Contents
• Dedication
• About the Author
• Preface
• Acknowledgments
• Part One: Foundations
• Part Two: Short-term Patterns
• Part Three: Long-term Patterns
• Part Four: Complex Patterns and Unique Assets
• Part Five: Managing the Mind
• Postscript
• Appendix A: Understanding the Thomson Reuters MarketPsych Indices
• Appendix B: Methods for Modeling Economic Activity
• Glossary
• Index
• End User License Agreement