In the past two weeks we covered key technical aspects related to investment in shares and their influence in the level of returns (both dividend and capital gain) as well as the performance of listed shares. We covered factors such as demand and supply; we discussed how these two market forces affects prices of listed shares. We further discussed how economic variables such Gross Domestic Price (GDP), inflation, interest rates, exchange rate, the state of current account and capital accounts, etc — and how these variables impacts the fundamental and sentimental performance of companies listed in the stock market. We also covered how company news results into the increase or decrease in share prices.
Today, we will delve not on technical aspects like we have done in the past two weeks — but we will focus our attention into the concept of market psychology and how, in addition to the technical analysis, it does inform our investment decision making. Later in our today’s article we will see how factors such as market cycles also affect market prices, and hence investment returns for investors in the stock market.
It is important to note from the onset that a good combination of both the technical tools and psychological factors can make a significant difference between a good investor and a great investor — we do not intend to say either technical aspect or psychological aspects, that one is better than the other. In actual fact, it is fair to say that when technical tools are used judiciously, their value in the process of investment can not be overstated. And every time, you, as an investor — apply a tool of technical analysis, you are (probably unknowingly) calculating a consensus of psychological — bullishness or bearishness — among all market participants. What it is, therefore is that the principles of market psychology underlie each and every technical analysis, so a good understanding of mob-psychology or crowd behaviour is crucial to your understanding of the fundamentals of particular technical indicators. Read on:
During our investment experience and processes, we probably have heard the efficient markets theory — basically, the theory of efficient markets are based on the assumption that rational people enter transactions with the intent to maximize gains and minimize losses. While this theory is sound, most investors are not the purely rational robots that efficient markets rely upon. Instead, emotions and other psychological factors often cloud our decision-making and prevent us and rational human beings from acting in a rational manner.
Knowing we can never conquer our inherent emotional and psychological biases, we should seek to understand the range of emotions we may experience as investors and how it affects our interactions with the stock market. A common market psychology cycle exists that shines light on how emotions evolve and the effect they have on our decisions. By understanding the stages of this cycle, we can tame the emotional roller coaster.
Market psychology is the overall sentiment or feeling that the market is experiencing at any particular time; greed, fear, optimism, hope, excitement, thrill, euphoria, anxiety, fear, desperation, panic, relief and other such related circumstances are all factors that contribute to the market’s overall investing mentality or sentiment. While conventional financial theory describes situations in which all the players in the market behave rationally, this theory do not account for the emotional aspect of the market that can sometimes lead to unexpected outcomes that can’t be predicted by simply looking at the fundamentals of the economy, the stock market or the underlying company.
Technical, analysts normally use trends, patterns and other indicators to assess the market’s current psychological state in order to predict whether the market is heading in an upward or downward direction
Market sentiment refers to the psychology of market participants, individually and collectively. It represents the general prevailing attitude of investors as to anticipated price development in a market. This attitude is the accumulation of a variety of fundamental and technical factors, including price history, economic reports, seasonal factors, and national and world events.
Market sentiment is perhaps the most challenging category because we know it matters critically, but we are only beginning to understand it. Market sentiment is often subjective, biased, and obstinate. For example, you can make a solid judgment about a share’s future growth prospects, and the future may even confirm your projections, but in the meantime the market may simply decide to dwell on a single piece of news that keeps the share artificially high or low. And you can sometimes wait a long time in the hope that other investors will notice the fundamentals.
Market sentiment is monitored with a variety of technical and statistical methods such as the number of advancing versus declining stocks and new highs versus new lows comparisons. A large share of overall movement of an individual stock has been attributed to market sentiment. In the last decade, investors are also known to measure market sentiment through the use of news analytics, which include sentiment analysis on textual stories about companies and sectors.
Emotions and perceptions
Share prices can change because of perceptions, greed, hype, euphoria, anxiety, desperation, panic and fear. Sometimes the stock market can be seen as the sum of the emotions of its human entrepreneurs and investors, subject to the arbitrary human whims and flights of fancy.
According to a Wall Street saying, only two influences are at work on the stock market – fear and greed. Most of the time they are in equilibrium, with greed only staying dominant long enough to produce the long-term trend depicted on a share market graph. The 1999 – 2000 technology boom was a good example of greed taking over. The Internet, and anything connected with it, became the spice of the moment and the technology companies shares skyrocketed in price. When it all got too much in Q2 of 2000 on the Nasdaq Stock Market – we probably recall what happened in the market place.
Bullish & Bearish
This is the other side of hype and momentum of the market. If investors are hopeful, they are thrilled and excited to the almost a euphoria status about the market and the economy at large — we expect upward price movement in the stock market, the sentiment is said to be bullish. On the contrary, if the market sentiment is bearish, most investors expect downward price movement. When a bear market sets in; fear, anxiety, panic, desperation takes share prices downward, to a long, bitter winter of discontent. During a recession nobody wants to buy shares. Only in hindsight do people realise that it was the best time to buy shares.
“To every thing there is a season, and a time to every thing, and a season for every activity under heaven”, says the author of the Book of Ecclesiastes in the Bible. The writer of Ecclesiastes, the most wise person on Earth, King Solomon, could have been talking about the stock market as well!
Most stock markets show a distinct seasonal pattern. It has a regular seasonal correction at the end of the financial year. This is normally followed by a major seasonal rallies i.e. beginning of the tax year, periodical financial reporting seasons, dividends announcements, quarterly Monetary Policy Committee (MPC) announcements by central banks, etc. These makes the stock market to more likely rise and fall in certain months than in others. Portfolio and fund managers tend to withdraw from the markets at the end of each tax year to balance their holdings. They start spending again at the beginning of the subsequent tax year.
Besides psychological factors that determine market prices and rates of return on share investments, there is a totally different concept to consider and that is the market cycle. Stock market cycles are the long-term price patterns of the stock market. It is very important for investors to know where the market is in its cycle at the time when they will be investing, particularly if they are entering the market for the first time.
Two key types of models that have been developed to help you to understand at what stage of the cycle the market is in are macroeconomic models and intuitive market models. For either type of model, the two most important factors in determining the market cycle will be the interest rates and monetary policy. To determine whether interest rates are favorable for share market investment, it is necessary to calculate their ‘real’ level (which is the current ninety-day bank bill rate, minus underlying inflation).
Along with macro-economic models, the other way to identify and predict market cycles is intuitive market models. Intuitive market models are imprecise and rely on subjective inputs from the investor – for example, where you think you are in the market cycle. Although they are partially based on economic conditions, they are mainly based on an intuitive understanding of how markets work.