March 01, 2015
Intellectual Imposters, Greece, and Emotional ETFs
Intellectual Imposters
As a psychiatrist I’ve worked at the fringes of human experience, and I've come to believe that it’s in those edge cases that we sometimes learn the most about ourselves.
Imagine awakening from a concussion to find that your spouse has been replaced by an imposter. Besides a minor headache you have no other problems - just that one. A stranger is pretending to be your spouse. She looks, talks, and lives exactly like your spouse, but you know - deep down - she’s not your spouse. Of course it doesn’t make sense intellectually that your spouse was replaced by a double, but you absolutely feel that way.
Capgras syndrome is the name for this disorder, and it is characterized by a delusional belief that a loved one has been replaced by an imposter. The feelings of strangeness win out over the intellectual understanding that this person looks and acts identically to your spouse.
For those with Capgras Syndrome, a break in brain circuitry disconnects the facial recognition area from the limbic system. The face of a loved one usually elicits an emotional response - joy, excitement, love. But after a blow to the head (or other neurological issue), this feeling is no longer experienced. Patients see their spouse with their eyes, but they don’t feel anything. In fact, while the skin of a normal person shows evidence of physiological arousal (slight sweating) when the image of a loved one is viewed, the skin conductance of those with Capgras’ Syndrome stays flatlined.
Because Capgras’ sufferers see the exact person (“yes, she looks just like my wife”) but don’t feel recognition (“I know she’s not my wife”), a battle ensues between reason and emotion in the brain. You might expect them to get on with life, living with the intellectual assurance that this person clearly must be their spouse. When everyone around them insists “this is your spouse, not a fake!” – that should hold some weight. But the brain accepts emotional input as superior to visual/intellectual input, and the patient remains doubting.
Because the Capgras’ patient feels no connection with the loved one, the only rational explanation (to the brain) is that she must be an imposter, a double. And the mind tends to attribute sinister motives to the imposter: “What did she do to my real wife?!” which can lead to violent behavior. An elaborate story is fabricated out of a simple disconnect.
But Capgras patients are not always upset by the imposters. One man with Capgras reportedly confessed to his priest that he had repeatedly been unfaithful to his wife – he had been sleeping with his wife’s doubles.
As investors we are often confronted with what we know to be true intellectually versus what we feel emotionally. “I know this market is overvalued on a historical P/E basis, but I feel like it will still go up.” Even as experienced investors who know we should rely on the intellectual assessments, the pull of emotional reasoning - reinforced by the media - is strong. As you can see in our ETF model below, the best investing opportunities come when we trade against both the emotions and the intellect of the media. This week’s newsletter examines the battle of reason and emotion, how that plays out in events such as a potential Greek default, and the cycles of belief that drive ETF prices.
Greek Default and the Emotion of the Crowd
When a democratic government is faced with two choices – one that is intellectually right but upsets voters versus one that is long-term wrong but satisfies voters, eventually the voters will win out. In the case of Greece, the voters elected a Syriza government in order to properly express their frustration. The decision to default - if it occurs - will be evidence of the power of collective emotion to trump intellect. Greek ministers now indicate they prefer to pay pensioners over the IMF, which may not be in the best long-term interest of those same pensioners (but if this is only a negotiating tactic, perhaps it is)."Shouldn't we negotiate this? We will fight it," he said in an interview with Skai television. "If we had the money we would pay ... They know we don't have it."
~ Greek Finance Minister Yanis Varoufakis, quoted in Reuters Feb 28, 2015
In 2011 a Greek default was anticipated to be a Lehman-moment. But by 2015 it is widely-recognized that Greece is 2% of the Eurozone economy, a default has been stress-tested, and the potential losses are fairly well understood. Although that doesn’t mean markets won’t wobble on fear of further contagion to Spain and Italy, it does imply that this event has been thought through. Sometimes emotions drive a self-fulfilling prophecy. If you treat your spouse (debtors, creditors,…) like a stranger, eventually they will become one.
But more often, we overreact to the fear that they will become a self-fulfilling prophecy, when they actually turn back from the brink. This emotional overreach creates a consistent mean-reverting pattern in prices.
Arbitraging Emotion Across ETFs
Two years ago one of our resident quant geniuses - CJ Liu, who happens to be skiing in Hokkaido this weekend much to our envy – set up a rotating weekly ETF trading model. We have been running his model forward in real time on our website every day over the past two years. The model uses only sentiments from our Thomson Reuters MarketPsych Indices (TRMI).
CJ's model – like all of our models - preys on the emotional drivers of behavior evidenced in Capgras Syndrome, using the alignment of reason and emotion to identify when investors are so absorbed by an emotional story that they miss the intellectual truth. These patterns occur so regularly that CJ has set up continuously rotating investment models that take advantage of these patterns.
In his ETF model, CJ first selected the TRMI with the most consistent and stable predictive power over weekly ETF returns in a simple rotational model:
- Anger (News),
- EarningsExpectations (Social Media, inverse),
- PriceForecast (News, inverse).
The model selected the top 10 (out of 28) most discussed ETFs in the news and then ranked them by this composite sentiment indicator. It went short the 4 lowest-ranked ETFs and long the 4 top-ranked ETFs. It does not account for transaction costs. An image depicting the ranking model as of Friday is below:
The table below represents the latest market outlook according to the strategy. High strength ETFs represent targets for investment, while negative strength represent weakness and should be sold. The ranking can be used as a guide for choosing regions for investment. It is important to note that the strategy itself only trades the extremes of the ranking, since that is where sentiment effects are more likely to occur.
This model has showed consistent returns in in-sample and forward-tested periods. The blue-shaded forward tested period was accrued over the past 2+ years. Our website’s Researcher-level subscribers have watched the theoretical profits accrue since 2013. See the equity curves of both in-sample and forward-tested ("Out-of-sample") in the screenshot below:
What does Capgras’ Syndrome have to do with an ETF trading model? (Maybe the only time that question will ever be asked). The most consistent market price patterns are driven by market emotions and fixed onto intellectual justifications (e.g., expressed beliefs that earnings and prices will continue to rise). This fixation gives us enough time to position ourselves for a reversal.
Extending the analogy to longer time frames – perhaps the best value investments are those that provoke strong aversive emotions in investors and have miserable fundamentals (or at least the fundamentals intellectually appear miserable, but in fact that misperception is fueled by negative emotions).
Housekeeping and Closing
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We love to chat with our readers about their experience with psychology in the markets. Please send us feedback on what you'd like to hear more about in this area.
Happy Investing!
Richard L. Peterson, M.D. and the MarketPsych Team