We realise that you will think your own experience while watching magic is unique to you, but we know that, in general, everyone thinks in more or less the same way. Even as it gets harder to apply a technological edge, applying a psychological edge offers us nearly limitless possibilities.
~ David Blaine

In his TED talk "How I held my breath for 17 minutes," magician and endurance performer David Blaine recalls several of his jaw-dropping performances. How magicians misdirect the attention and perceptions of groups has lessons for investors, which we will explain deeper in this newsletter.

One of the wonderful things about the art of magic is that it doesn’t really matter where the trapdoor is. That’s not the secret. The secret is that magicians influence what you think by using your own preconceived ideas of the world around you to amaze you.
~ David Blaine

Gustav Kuhn, a cognitive psychologist and magician, studies how magic tricks work. In one study Kuhn threw a ball into the air. When it came back down he caught it, and he threw it back up in the air, his eyes following it up. He did this twice, and on the third throw he pretended to throw it up while his eyes tracked the invisible arc of its course. Two thirds of the participants reported seeing the ball vanish in mid-air, even though it never left his hand. In a second condition, he pretended to throw the ball in the air, but instead of tracking it with his eyes, he stared at the ball in his hand. In that condition only one-third of the subjects believed he had thrown the ball into the air. Participants misperceived the actual event based on their expectations, as set by the magician.

According to Kuhn, "Even though the ball never left the hand, the reason people saw it leave is because they expected the ball to leave the hand. It's the beliefs about what should happen that override the actual visual input."

As humans we are hardwired to perceive patterns and to develop beliefs that even reality cannot shake. Magicians learn how to set beliefs, misdirect attention, and trick our senses. Some of their tricks parallel the ways in which markets collectively fool investors.

In today’s newsletter we review what we can learn from magicians, the untethering of the Swiss Franc (CHF), this weeks’ tech stock earnings, recent quantitative stock results, and when we should believe our market perceptions versus when we should doubt them. As usual it's a fairly long newsletter today, so feel free to skip ahead to the topics or images of interest.

Magic at the Swiss Central Bank

By chance I went to dinner with a Swiss central banker shortly before the CHF/EUR cap was instituted on September 6, 2011. My new acquaintance didn't eat much at the restaurant, and he looked ill - grayish-hued, shifty-eyed, and perspiring. As he described the billions of CHF in interventions the bank was performing in order to keep the CHF from appreciating versus the EUR, he wondered aloud to me, “where will this all end?” Like most investors, central bankers realize that we are in uncharted monetary territory.

On January 15th the Swiss central bank abandoned its trading cap versus the Euro and the franc increased 23% versus the Euro in one day. The benchmark interest rate was lowered from minus 0.25% to minus 0.75%, meaning bank depositors would be paying even more to keep their funds in a Swiss bank account.

When a currency makes a huge move, some win and others lose. According to the New York Times, hundreds of thousands of Eastern European borrowers took out home and consumer loans denominated in CHF due to the two-thirds discount on interest rates versus loans denominated in local currency such as the Polish Zloty.

Based on our data, most currency investors were fooled. Over the past several months the consensus PriceForecast for the CHF was trending down, indicating the media was confident the cap would hold and the CHF would follow the EUR down. This is consistent with a FT Alphaville review of FX message boards after the event: "Discussion of trading strategies on FX message boards suggests many were [on the wrong side of the trade]." However, in our data over the past 10 days there was a small uptick in chatter that the CHF would rise in value.

Predicting Currencies

It is possible to identify and take advantage of subtle shifts in investor attention about currencies. We’ve been running a weekly currency arbitrage strategy on our website in real time over two-years. Below is a screenshot from our website's weekly currency model. This model uses a number of sentiment and macroeconomic indexes that have been found predictive of weekly currency movements - the list of indicators is below under "Primary Indicators."

This model indicates that the Swiss Franc should sell off further in the next week (as it has already been doing).

The equity curves of this strategy are also available on our website and are updated daily. The forward-testing (live performance) was recorded in the blue-shaded area in the screenshot below. Shorting the Russian Ruble was a particularly helpful trade recently:

Feel free to contact me for more information about this model, as we have currency white papers and research that we do not distribute publicly.

Earnings: Apple, Google, Microsoft

The largest tech companies reported their earnings last week, and the consensus is that Google and Microsoft disappointed, while Apple amazed. When we look at our social media data, we see that these events were anticipated. In both social media and news, our EarningsForecast index - an index we construct by quantifying all conversations about future earnings rising versus falling – accurately predicted this week’s earnings. EarningsForecast is intended to accurately reflect public earnings expectations mentioned in the media. Like all of our indexes, it is generated in real time by quantifying the firehose of news and social media information.

In the chart below, we see that the earnings of the largest tech companies were accurately anticipated by social media (a similar pattern is seen in news).

While institutional analysts had broadly incorrect earnings forecasts, the investing public was not fooled. However, the public is more likely to be fooled when high or low Sentiment is present. Our Head of Research CJ Liu found that over 1-2 days markets follow the Sentiment trend, but over one weeks to one year prices move away from the prevailing Sentiment.

Good News is Good (for 1-2 Days)

In the ball-tossing magic trick at the opening of this newsletter, a consistent pattern of tossing the ball into the air and catching it was first established. Once that pattern was understood by viewers, and expectations set, only then could the illusion work.

Something similar occurs with stocks. Good news does lead to positive price movement for 1-2 days (the set-up). But after that, prices tend to reverse (the illusion).

The below equity curves were derived from U.S. and Canadian stocks in separate studies. One half hour before the NYSE close, we look at the past 24 hours of sentiment for the most Buzzed-about stocks in each country (top 200 in the U.S.; top 20 in Canada). We ranked each stock by its average level of Optimism (U.S.) or Sentiment (Canada) over the past 24-hours. We then simulated going long the top 20% (most positive sentiment) and shorting the bottom 20% (most negative sentiment) at the market close, 30 minutes after the data point is published. The following day at the close – 24 hours later - we exited those positions and rolled into new ones. The equity curves derived from this analysis are plotted below. Returns were not adjusted for transaction costs, and there may be no profit once those are factored in. Nonetheless, this is a simple and general strategy which establishes the short-term trading advantage to be gained using sentiment. The equity curves start at a theoretical $1 in 1998.

For the news Optimism index below, we see returns > 30x for U.S. stocks.

For the news Sentiment index below we see returns of > 75x for Canadian stocks.

Good news makes the price rise. Bad news and the price falls. That relationship is straightforward, and in our research it is fairly consistent globally. There is no magic to it.

However, investors learn this pattern and several days later, as they continue to pile in and feel good about themselves, the price unexpectedly rolls over.

The Joke is on Us

…Houdini engaged his audience emotionally, by playing to their hopes and fears. That is why it worked so well.
~ David Blaine, describing the technique of Harry Houdini’s hanging straightjacket escapes

When emotion is provoked during a magic trick – regardless of whether happy or tense - the audience is more likely to be distracted. Consider the “saw the lady in half” trick, which is revealed here on Wikipedia. During the event, the drama of the trick - plus visual illusions - blocks critical analysis of how the viewer could be being deceived.

It’s hard to think critically if you’re laughing. We often follow a secret move immediately with a joke. A viewer has only so much attention to give, and if he’s laughing, his mind is too busy with the joke to backtrack rationally.
~ Teller. 2012. “Teller Reveals His Secrets.” Smithsonian Magazine.

High levels of emotion blind investors to rational considerations. In the examples below, we see this effect from social media for two emotional indexes.

Speculation is a combination of upwards projections of an asset's price and positive emotion. Rational analysis focuses on business fundamentals. The net difference between the total positive speculation about an asset versus rational analysis of it constitutes the MarketRisk index. We custom-built the MarketRisk index (a.k.a. the Bubbleometer) to quantify speculative activity versus rational analysis of stocks.

When we look at stock performance on a weekly basis in the U.S., we see that the level of MarketRisk is inversely correlated with weekly stock returns. Shorting on high MarketRisk - during high speculative activity, reflecting positive emotions - and buying on low Market Risk during more rational, analytical thinking - is a good strategy. See the equity curve below derived from arbitraging the quintiles of the top 20 U.S. stocks by Buzz on a weekly basis.

We also see in the equity curve below that it is useful to buy on weekly Stress (and short low-stress stocks). A similar contrarian idea to that of MarketRisk.

This contrarian effect isn't limited to the U.S., nor to weekly periods. Below is an arbitrage of monthly Joy in China. We should short the most Joyful Chinese stocks, and buy the lowest Joy on a rotating monthly basis.

While in the short term all looks happy and positive, investors become attached to these feelings and relax their critical thinking. Investors miss the sleight-of-hand as prices turn around, and they are caught by surprise.

Integrating the Lessons of Magic

My chief task has been to conquer fear. The public sees only the thrill of the accomplished trick; they have no conception of the tortuous preliminary self-training that was necessary to conquer fear. No one except myself can appreciate how I have to work at this job every single day, never letting up for a moment. I always have on my mind the thought that next year I must do something greater, something more wonderful.
~Harry Houdini

How can we conquer fear and hone our perceptions? At MarketPsych we’ve written many newsletters (and even books) about managing fear. And we've created our data in order to use emotion objectively, as a quantitative arrow in our market quiver.

In this respect the art of magic may carry a wider lesson for our technology obsessed age. As in many professions in 2015 and beyond, it is the primitive skill of understanding people, perceptions and relationships that will increasingly matter.
~ David Blaine

Some investing models – such as those based on our data - are designed take advantage of human misperceptions.

Housekeeping and Closing

Like investing,

Whether you're shuffling a deck of cards or holding your breath, magic is pretty simple: It comes down to training, practice, and experimentation, followed up by ridiculous pursuit and relentless perseverance.
~David Blaine

The good news is that we aren't doomed to forever falling into the same perceptual traps. According to this psychology of magic study, we can improve in detecting perceptual foolery with practice.

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.

I am a great admirer of mystery and magic. Look at this life - all mystery and magic.
~Harry Houdini

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.

Let's not be fooled,
Richard L. Peterson, M.D. and the MarketPsych Team

References

Barnhart, A.S. and Goldinger, S.D. (2014). Blinded by magic: eye-movements reveal the misdirection of attention. Front. Psychology doi: 10.3389/fpsyg.2014.01461
Kuhn, G., and Tatler, B. W. (2005). Magic and fixation: now you don't see it, now you do. Perception 34, 1155–1161.
Kuhn, G., Tatler, B. W., Findlay, J. M., and Cole, G. G. (2008b). Misdirection in magic: implications for the relationship between eye gaze and attention. Vis. cogn. 16, 391–405.
Olson, Jay. (July 31, 2012). Revealing the Psychology of Playing Card Magic. Scientific American.
Teller. (2012). Teller Reveals His Secrets. Smithsonian Magazine.

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