I grew up in West Texas, near where wildcatters such as George Bush senior made their fortunes. Oil pumpjacks, rusty and retired after the oil price collapse in the early 1980s, sat idle across the scrubland near my house. For high school kids, those pumpjacks were popular props for spending weekend evenings. There was nothing more pleasant than laying on the cold steel of a pumpjack under the stars, chatting with friends, a bonfire burning far below us.

Being adolescent and thus maintaining our right to poor judgment, it hadn't occurred to us that lighting bonfires on top of decrepit oil pumpjacks could lead to a lethal explosion. It took an incredulous county sheriff to point that out to us one night.

The oil price, and the stocks of companies in the oil sector, have been devastated over the past 18 months. Those West Texas pumpjacks are sitting idle again, starting to accumulate rust. Given the carnage in what was once one of the best-loved sectors of the financial markets, it's a good time to see how sentiment is influencing the future of energy prices. We described a few crude oil patterns in a 2013 newsletter (from which the above introduction was lifted). And then in a newsletter 13 months ago we mentioned a sentiment-based indicator for crude oil that has remained useful through today.

The 2007 movie "There Will be Blood" was based on the book "Oil!" by Upton Sinclair and captured the ruthless ambition of oil wildcatters in the early 1900s. Oil has long held a tight and dangerous grip on the imaginations of speculators. In order to understand how oil markets are likely to evolve over the next year, it helps to empirically evaluate how sentiment drives oil prices.

Price Patterns and Sentiment

Daniel Plainview (played by Daniel Day Lewis): Are you envious? Do you get envious?
Henry Brands: I don't think so. No.
Daniel Plainview: I have a competition in me. I want no one else to succeed. I hate most people.
Henry Brands: That part of me is gone... working and not succeeding- all my failures has left me... I just don't... care.
~ There Will be Blood (2007)

In general, statistical analysis of price patterns demonstrates the existence of two opposite sentiment-based patterns in financial prices: overreaction (e.g., panic bottoms and blow-off tops) and underreaction (e.g., trends). The concepts of underreaction and overreaction refer not only to patterns of prices but also to the collective investor reactions to information that fuel such patterns.

As most of our readers are aware, in partnership with Thomson Reuters MarketPsych derives and distributes the Thomson Reuters MarketPsych Indices (TRMI), representing a real-time quantification of emotional and macroeconomic references in the media to 8,000 companies, 52 stock indexes, 32 currencies, 35 commodities, and 130 countries. When the sentiments extracted from such text are statistically analyzed alongside historical price data, insights emerge into how such information moves crowds of investors and prices themselves. Oil is one of the more sentiment-driven asset, based on our testing.

Underreaction: The Trend is Your Friend

If I told you I knew a place that had oil, where land could be bought cheaply, what do you think that would be worth?
~ Paul Sunday, There Will be Blood (2007)

Price patterns based on underreaction often occur in response to boring, routine, or complex information. Information such as the steady growth of oil inventories or technical improvements in fracking productivity may be initially overlooked by investors whose attention is drawn to more vivid, dramatic information such as proclamations from OPEC or war damage to oil production equipment. As investors slowly realize the meaning of the accumulated information, they gradually buy (or sell), slowly moving prices.

Measuring media sentiment around commodities is a difficult exercise. Producers and consumers of commodities have polar opposite perspectives on events that affect the commodity’s price. Rather than using sentiment itself to identify trends in perceptions around commodities, the priceDirectionTRMI appears to be a useful stand-in. This TRMI was derived by quantifying references to the price of an asset increasing net of references to the price decreasing. The predictive value of the priceDirection TRMI for crude oil was first noted in 2012, and it has remained impressive since it was first identified, including forecasting the more than 50 percent oil price slide over from mid-2014 through 2015 as well as the recent declines, as depicted below.

From 1998–July 21, 2015, the moving average crossover (MACD) depicted above yielded a 7 percent average annual return, turning a hypothetical $1 at the beginning of the period into $3.12, excluding any borrowing or transaction costs.

Underreaction to the Dramatic

There's a whole ocean of oil under our feet! No one can get at it except for me!
~ Daniel Plainview, There Will be Blood (2007)

Sometimes news that frightens investors has a slow impact on prices. Aleksander Fafula ran a series of simple data mining experiments to understand how media references to conflict, violence, and fear preceded oil price moves over the past 15 years. The Conflict TRMI refers to high levels of dispute and disagreement surrounding the oil markets, fundamentals, prices, and other topics. The Violence TRMI encapsulates military threats and actions associated with the oil market. Fear is a measure of references to “worries,” “concerns,” and other symptoms of anxiety surrounding oil prices.

Using the TRMI as independent variables and price changes in the highest-volume futures contract of West Texas Intermediate Crude as a dependent variable, extreme levels and changes in media fear, conflict and violence around crude were examined over the period 1998-2012 using association rules.

The monthly return patterns associated with these indexes creates an interesting story. First, when the news of a conflict or potential war hits the newswires, it precedes a spike in oil prices. Importantly for traders, that spike has momentum—oil prices continue higher for the following one month. For example a one-week spike in the crude oil Violence TRMI, which occurred 91 times in the study period, preceded an average +2.2 percent average oil price return over the following month. One-week spikes in conflict had a similar effect (94 events, +3.2 percent average one-month return). See the table below.

These “spikes” occur with a frequency of approximately 13 percent of weeks (about 6 weeks per year). There is a similar positive momentum effect for Fear, but only during extreme surges. A rise in one-week fear greater than 90 percent of all such spikes happened 19 times with average 3.2 percent next-month returns. A summary of monthly results is visible in Table 19.1. Examining two variables together, such as when conflict rises AND productionVolume drops, the next month return averaged 8.2 percent (28 occurrences in the 15-year sample with 82 percent directional accuracy). This is an important result because it is reasonably common and it makes sense—both conflict AND concerns about declining production together drive prices higher than either one alone. Importantly, oil prices seem to react sluggishly to many types of new information. Oil traders have time to enter into positions based on these signals.

Overreaction: Buy on the Dip

"Saudis 'ready to cooperate' on crude output"
~ CNBC headline, Jan 28, 2016
"Oil rallied this week on false hopes for OPEC deal"
~ CNBC headline, Jan 29, 2016

The contrarian nature of market psychology has long been referenced by market gurus. Baron Nathan von Rothschild, an early scion of the Rothschild banking dynasty, in 1812 guided investors to, “Buy to the sound of cannons, sell to the sound of trumpets.” Benjamin Graham wrote, “We buy from pessimists, and we sell to optimists.” Warren Buffett modernized the saying as, “Be fearful when others are greedy and greedy when others are fearful.” These are some of history’s greatest investors, and they reference the importance of buying what no one else wants in their investment advice. Yet the findings described above for crude oil did not fit the meaning of Rothschild's, Graham's, and Buffet's advice. Why not?

If prices are pushed too far, the theory goes, then rational investors will take the other side of the trades and the opposing pressure of their orders will bring prices back towards fair value. Following dramatic information, this pattern is most likely (the "dead cat bounce"). In each asset, it is best to measure how traders respond to information. Prices react differently over different time periods.

While large jumps in media references to fear, violence, and conflict historically preceded oil prices higher, high absolute levels of such sentiments lead price declines (a sign of overreaction after sustained drama). On a monthly basis—over the interval (1998–2012) - when monthly crude oil fear was in the top 10 percent of historical values, the crude oil price declined every one of the following months with an average loss of 5.4 percent. For conflict values in the top 20 percent of the historical range, the average next-month drop is –3.2 percent (37 samples). See the Table below.

The most complex finding in the table indicates that when urgency declined (a crisis ends), AND conflict remained high, there was a predictable opportunity to short oil and profit. After the above patterns were identified in oil prices, there were several opportunities to test them in real-time. For example, after Islamic State routed Iraqi soldiers and seized Mosul in June 2014, fear rose and oil prices spiked. Throughout the remainder of 2014 no additional production disruption fears hit the market, and the oil price fell 60%. In another example, the Syrian government’s use of chemical weapons on civilians prompted the West to threaten airstrikes against Syrian President Assad. Iran was a backer of Assad, and oil markets were put on edge in August 2013. The New York Times reported: “Iran’s and Syria’s defense ministers threatened on Friday to unleash attacks on Israel if Mr. Assad was in danger.” Yet the West did not engage in airstrikes against Assad, and crude oil prices predictably dropped in the subsequent month. While the aforementioned results are based on crude oil alone, groups of similar commodities such as precious metals, grains, and livestock have been studied with association rules and also yielded positive results.

Value investors search for stocks that are inexpensive, with high earnings-to-price ratios. Value investors often reference the value of buying on fear, but others advise against "catching the falling knife."

Value Traps?

"Spending cuts at Hess, Noble are just the start for oil sector"
~ MarketWatch headline, January 27, 2016

Given the carnage in the energy sector, some investors speculate that now is a good time to buy distressed energy assets. Psychologically speaking, there should be no hurry. Our indicators do not support a reversal in prices above $40/barrel for oil. In fact, the price may hover around $30 until even deeper distress knocks out surviving producers. So far production hasn't flagged at these levels despite a large build up in inventory. Perhaps next year will see more fire sales as the larger energy firms start to trim down in earnest.

In order to test Warren Buffett’s advice to buy on fear, CJ Liu statistically examined the returns of stocks that are both value stocks and associated with high media fear. Using an annual holding period and starting at a notional $1, the returns since 1999 of the top 5 percent of S&P 500 stocks by value (earnings-to-price ratio) are plotted in below in the light gray line. The equity curve of a subsection of stocks that are both value stocks and associated with high fear are represented in the darker line.

Buying value stocks that are also high in fear outperforms a typical value strategy by threefold from 1998 through July 2015, with more than twentyfold overall returns. Importantly, this is a conceptually simple strategy, and it has been described anecdotally by distressed asset investors, lending further support to its legitimacy.

From what we can see, it's only useful to buy on fear if the fearful assets are also relatively inexpensive (values). Importantly, energy stocks aren't cheap, based on their earnings, at this time. Sometimes they will appear to have high dividends or earnings based on past numbers, but the future portends much lower numbers. Buying on fear alone isn't a consistent strategy in CJ's research, and it can lead to getting stuck in a value trap - a stock with declining earnings. Until real value becomes apparent in the materials and energy sector, it's best for long-term investors to avoid it.

Housekeeping and Closing

Investors who objectively consider the emotions of the crowd find that the gap between feelings and reality is the source of many market opportunities. At times feelings overwhelm cold reality, and prices become driven by collective emotions. Prices often bounce after such events. Conversely, information that is too complex, boring, or in disagreement with investors’ prejudices is ignored, and price trends form as investors underreact to it.

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.

If you represent an institution, please contact us if you'd like to see into the mind of the market using our Thomson Reuters MarketPsych Indices to monitor real-time 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.

Investing from the mind AND heart,
The MarketPsych Team

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