Brains, Bubbles, and Arbitraging Global Exuberance

The Manic-Depressive Mr. Market

Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
~ Ben Graham, Chapter II, The Investor and Stock-Market Fluctuations, p. 42

Investing legend Benjamin Graham developed a character - the manic-depressive Mr. Market - to account for the emotional swings that course through financial markets.  According to Graham, the erratic moods and behavior of Mr. Market provide opportunities.  If investors can wait until Mr. Market is in a pessimistic mood and offers a low sale price, then investors who buy his pessimism can increase the expected value of their investments dramatically.   Similarly, investors can sell to Mr. Market for an irrationally high price when he is unduly optimistic. 

The chart below, explained in more detail at the end of this newsletter, is the equity curve of a strategy that takes advantage of Mr. Market's mood swings across global stock markets.  It is modern evidence that the swings of optimism and pessimism matter, perhaps more than any other driver of market prices.



In our prior newsletters we examined two of the top traits of investors: intuitive expected value calculation and adaptability.  In today's newsletter we will begin examining the final trait of the three - emotion management.  Because this is a lengthy topic, we are splitting emotion management into three additional newsletters:  exuberance, fear, and stress management.  Today we focus on irrational exuberance: how it throws our analytical prefrontal cortex offline, how to manage it, and how to trade it across global markets.

What Is the Definition of Is?

Patience is an essential virtue when dealing with Mr. Market, but patience is the most difficult thing when prices are moving.  Patience is difficult because of the primacy of emotion in driving our investing behavior.  We don't THINK emotion is very important, because we are thinking about emotion with the brain's prefrontal cortex.  The prefrontal cortex evolved 100,00 years ago, and it is what makes us characteristically human - engaging in rational planning, abstract thought, strategic decision making, and self-reflection.  Yet the prefrontal cortex evolved ON TOP OF the limbic system, which governs emotion and motivation.  At times the prefrontal cortex is knocked offline by emotional surges, and when it is placed back online, it tries to clean up the mess as best it can.

Homer portrayed the struggle between the limbic system and the prefrontal cortex most eloquently in the depiction of  Ulysses and the Sirens.


 
Ulysses passed the Sirens safely only because his crew refused to untie him, and they themselves had their ears plugged.  But most modern would-be heroes are usually not so far-sighted.  Bill Clinton, Dominique Strauss-Kahn, and countless other leaders sailed too close to the Sirens (deliberately so, in their cases), leading to such famous gaffes as Clinton's assertion that: "It depends on what the definition of is is."  When intense emotions arise, like lust or exuberance, the prefrontal cortex plays little more than an observer role in what comes next.  
 

How Your Brain Shorts a Bubble

You may be happy to sell out to him [Mr. Market] when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings....
~ Ben Graham, Chapter II, The Investor and Stock-Market Fluctuations, p. 42

As we've written before, many of the best investors absolutely hate taking losses.  This intense focus on managing the downside keeps many of them in the markets over decades.   It's also true that the best investors are not susceptible to market exuberance.  They have early-warning radar that quickly alerts them to siren songs - to the speculative exuberance that is luring others onto the rocks.  New research out of CalTech pinpoints this neurological mechanism behind this skill.
 
In an experimental bubble environment, CalTech researchers found that the best investors have an early-warning system located in their brain's anterior insula.  We've written about the anterior insula before, as this area predicts when investors will avoid risk (even irrationally so).  The brain's anterior insula is also activated by disgusting smells, electric shocks, and financial losses.  In the context of market exuberance, an active anterior insula predicts advantageous selling.

...We report a signal in the anterior insular cortex in the highest earners that precedes the impending price peak, is associated with a higher propensity to sell in high earners, and that may represent a neural early warning signal in these subjects.

Investors who listen to their risk-detection early-warning system make more money during an experimental bubble. 

And in the same experiment, another brain region predicted underperformance of investors.  The subjects who performed the WORST in the CalTech experiment were those who bought during an activation signal in the brain's Nucleus Accumbens, part of the brain's reward center.  Note that the Nucleus Accumbens is activated by many desires:  expectations of making money, cravings for illicit drugs, seeing desired luxury goods (women), and the prospect of punishing another in revenge (men).  The reward system compelled the worst performers to "Buy Buy Buy!" right at the top of the bubble.  They could not resist the Siren song of instant wealth.
 

Stock Promoters and Irrational Exuberance

OK, first rule of Wall Street - Nobody - and I don't care if you're Warren Buffett or Jimmy Buffet - nobody knows if a stock is going up, down or f-ing sideways, least of all stockbrokers. But we have to pretend we know.
~  Mark Hanna (played by Matthew McConaughey), Wolf of Wall Street

When Jonathan Lebed was 15 years old he posted a pump-and-dump pitch 200 separate times on Yahoo! Finance stock message boards. Two days later he was subpoenaed by the SEC.  Mr. Lebed was a teenage stock promoter, and we briefly wrote about about his skill in this prior newsletter, which was based on this fascinating Michael Lewis article about his case.  Stock promoters like Lebed are experts at working Mr. Market into a froth of manic optimism.  This optimism causes investors to buy at the high (from the promoter's clients, who are selling).  Stock promotions sometimes cross the legal line into pump-and-dump schemes. 

How do promoters convince so many suckers?  They ease the prefrontal cortex offline.  Like Sirens, stock promoters deploy tricks to prompt investors into buying stocks without thinking about the decision using the following steps:
1.  They buy some shares of the company to get the price moving upwards.  The positive trend is price confirmation, and it engenders confidence.
2.  They convince a canned expert - even as suspect as the company's own CEO - to make a positive public statement about the company.  The authority effect lulls the anterior insula into submission - "He knows best!" - this trust allows the nucleus accumbens to take over with guiding risk-taking decisions.
3.  Unlimited projections of potential profits are suggested - "could go even higher than 10x!" Astronomical expectations (optimism) ramp up activity in the nucleus accumbens.
4.  There is insufficient information available to use typical valuation metrics.  "Initial data indicates their Chinese gold mine is the richest in history!"  A lack of anchors and uncertainty actually amplifies the positive emotion being experienced.
5.  Investors need to act quickly: "Get in quick before the stock ROCKETS!" Urgency high-jacks the limbic system into taking the prefrontal cortex offline.  There is no time for rational thought/analysis, so the emotional system makes the decisions. 

Those five ingredients, plus some bold type and exclamation points, are the main tools of the stock promoters trade.  MarketPsych's text analytics captures several of the above 5 factors, and as we demonstrate below, they are applicable not only to single-stock pump-and-dump schemes but also to entire global asset classes.
 

Selling to Optimists

When you buy a stock, because it has surplus assets or a good yield or a great safety margin, you are really making a bet on regression to the mean. We are really counting on the fact that current unpopularity will fade, that the current problems in the industry will dissipate, and that the fortunes of war will move back to normal. ... The aggregate stock market of a country is more provably mean-reverting when mispriced than sectors. And great asset classes are provably more mean-reverting than a single country.
~ Jeremy Grantham, April 2010

Jeremy Grantham's observation above is consistent with our statistical research.  Fortunately, and with the power of big data and media analytics, we can now quantify, test, and trade on such observations.  The investment returns to be gained from following such mean-reversion strategies appear impressive.
 
Today's newsletter demonstrates research on the positive sentiments and emotions that predictably drive prices.  Next month we'll  look at the negative ones (whose returns are even better than the positive).
 
The following studies on exuberance and mean-reversion across countries were performed by an uber-genius and - we're very fortunate to say - MarketPsych's Head of Research, CJ Liu. Because news flow is nonlinear, occurring in bursts and focused on periodic events, CJ used a cross-sectional study method.  His technique examines returns following symmetrical extremes of sentiment.  We call this analytic technique "emotional arbitrage."  It captures the psychologically-driven mispricings caused by macroeconomic information and tones conveyed in the news.
 
Each of our news-based sentiment indexes (Thomson Reuters MarketPsych Indices - TRMI) were averaged over the prior 12-months, rolling forward every month since 1998.  The top 20 countries with the most news Buzz for the prior 12-months were selected for further modeling.  Non-tradeable countries - those without ETFs like Libya, Afghanistan, and Iraq - were excluded.  The top 20 countries by Buzz were then ranked by their average past-year value for a TRMI.  The top 4 countries ranked on that TRMI were shorted, and the bottom 4 were bought as longs and held for 12 months. 
 
The stock returns of the primary equity index for that country were averaged for the top 4 and bottom four countries to give a composite equity curve for each ranking.  The model was rolled forward monthly and 1/12 of the portfolio value was re-invested each month.  As a result, the average holding period per position is at least 12 months (averages 15 months).
 
Note that in the equity curves below, the preceding "-" sign indicates that the models go SHORT the top 4 countries and LONG the bottom four countries on the index. The equity curves represent an absolute return model that is uncorrelated and shielded from global events.

Global Results

 
On a broad analysis, a high level of overall emotionality about a country is generally a negative predictor of prices. 

 
Our EmotionVsFact index captures the number of emotional references about a country versus the factual ones.  High emotionality appears to precede negative returns. 
 
Supporting the work of stock promoters is the finding that buying in Urgency is a poor strategy.  As Ben Graham noted, when dealing with Mr. Market, patience pays...
 

 
Joy (exuberance) is also inversely correlated with returns.  Trust is elicited as part of the Authority Effect by pump-and-dump schemers, and it shows inverse returns below:
 

 
It is easy to invest in a country whose government and business conditions are trustworthy, but it leads to a lower risk premium and lower overall returns.  It's also notable that buying joyful countries is a negative strategy.  We should prefer to buy misery.
 
We also find that other markers of exuberance such as LoveHate and Innovation (often discussed as a topic by exuberant investors) are inversely correlated with returns.
 
Interestingly, for country news the broad indexes of Sentiment and Optimism have no appreciable relationship with equity prices.  However, SOCIAL MEDIA Optimism is strongly inversely correlated with future country stock index returns.  Note the historical 10x return gained by arbitraging social media Optimism across countries since 1999.
 

 
It appears that global social media optimism - populated by noise traders - is likely to best reflect irrational exuberance across countries.  Of course, the inverse of Optimism is Pessimism, and this equity curve also shows that buying Pessimism is of value.
 
In summary, understanding emotion and the mechanics of irrational exuberance and patience are crucial to forecasting global equity prices on a macro level.  In next month's newsletter I'll show how buying from pessimists yields even more fantastic absolute returns.
 

Investor's Corner

 
The current global map of last quarter's Optimism from Social Media through August 31, 2014 is below.  With your website login, hovering over the chart reveals the numeric values by country.  Note the surprising optimism in Portugal:


 
To see our investment perspective (available below for subscribers) and explore our charts, please consider the Professional plan.  Please contact us directly if you represent an institution.

Managing Your Emotions

 
This newsletter focuses on exuberance, and in this section we explore a few techniques for getting a handle on your own enthusiasm so you will be well-positioned to take advantage of Mr. Market's. 

1.  Practice patience when you feel emotions getting the best of your judgment.  Make this a priority.  Like Ulysses, enlist others to help you.
2.  Stick to a consistent analytic framework.  Don't let urgencies shake you off course.
3.  Listen to your brain's early-warning system (anterior insula) when others are crowding into one of your positions, and use it to improve your analytics and risk management.
4.  When you find yourself caught up by a compelling story, check whether it meets the following criteria:
   A)  Comes from a trustworthy source,
   B)  Needs to be acted on urgently,
   C)  Contains positive projections that you want to see realized.
   D)  Contains an element of excitement or enthusiasm
If so, consider trading against it.

Housekeeping and Closing

 
We'll be back in Chicago next week and we will be in Hong Kong and in Singapore the week of Sep 22-25.  We look forward to seeing our friends in those cities.  Please contact Derek Sweeney to book us for a talk or training at one of your events: Derek@thesweeneyagency.com, +1-866-727-7555.
 
New research on our global TRMI data is gradually coming out.  Here is a working paper on the role of information leakage:  The Adverse Effects of Systematic Leakage Ahead of Official Sovereign Debt Rating Announcements.  If you are a university researcher, we encourage you to contact us for a data sample to use in your research.

Please contact us if you'd like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor market psychology and macroeconomic trends for 30 currencies, 50 commodities, 130 countries, 50 equity sectors and indexes, and 8,000 global equities extracted in real-time from millions of social and news media articles daily.

We love to chat with our readers about their experience with psychology in the markets and with behavioral investing!  Please send us feedback on what you'd like to hear more about in this area.

Happy Investing!  But not too happy...  ;-)
Richard L. Peterson, M.D. and the MarketPsych Team