Using A Science Based Approach to Markets – Market Psychology

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“Davidson” submits:

Why has the guidance I have provided stood up since early 2009 in spite of the considerable number of swings in consensus investment opinion?

The short answer is, ‘I am by training a ‘scientist’.’  Facts are stubborn things. They hold over the test of time and survive changing opinion. This is why they call them ‘Facts’. I was always geared to discovering the fundamentals of things. This leaning led me to a scientific education the end of which I received a PhD in Physical Organic Chemistry. But I found the corporate world unfulfilling and after a short stint as a research/product development chemist at a Fortune 100 firm. I entered the world of finance in 1982 and found a world in which fact and fiction were often treated with equal importance. I saw differences but it took quite a bit longer than I expected to finally have it all make sense to me.

Investment markets filled to the brim

The ability to separate out fact from belief, myth and outright deception is no where more important than in the financial market place. Investment markets are filled to the brim with many ‘experts’ telling us what to do each day and why we should give them our investment capital. Of course we rarely hear that any of them have delivered on their promises. It is the task of sorting fact from fiction, defining reasonable expectation from the thousands of promises offered which is the basis of my investment research.

Having an ‘eye for facts’ forces one to look at the ‘Big Picture’ differently. It becomes apparent over time that human beings confuse facts with how they think things should be. Looking for instant gratification is our ‘big fail’ as fact based results have a longer gestation than we are prepared to accept. Human beings often believe visual patterns over the underlying factual trend especially if we believe our interpretation of what we see is gratified by an immediate extension of the pattern. We quickly assume that what we have come to understand is true and find reasons to justify and support our belief. This is the dominant driver in the investment markets.

What has occurred over the past 100yrs has been the belief that mathematics can unravel the truths embedded in the countless trillions of transactions if only we could discover and apply the right algorithm with the right amount computing power. It is the confusion that computers and mathematics will provide this solution which reigns today. In fact the use of computers to predict outcomes using all sorts of information has developed a prominence unequalled in our society. We believe we can convert almost any subject material into a ‘scientific study’ by using computer/mathematics. Not every subject should be treated scientifically. Much which occurs around us and which we try to measure is not factual. But, we ignore these differences and submit factual and non-factual inputs alike to computers and then tweak our algorithms to produce results which we believe are ‘buried’ in the information we input. Because we believe that ‘computers cannot lie’, we accept the output as factual even when the input was not factual! Computers cannot convert non-factual information into factual information! Factual information cannot be used to predict non-factual results. This is why I do not provide precision to stock prices or market prices.

The belief in computer output as factual regardless of our input is self-delusional! This is not the first time humans have done this. We are all aware of the story of ‘The Emperor’s New Clothes’.

Facts are stubborn things! This comes from John Adams 1770 defense of soldiers charged with committing murder at the Boston Massacre. “Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passion, they cannot alter the state of facts and evidence” John Adams 1770. ‘Facts have a durable quality. Facts are hard/unchanged through time. I have used as an example of ‘fact’ the commonly known chemical combination of hydrogen and oxygen to form water as one which is not altered in time nor space. Water and how it is formed is the basis of scientific advancement and mathematical development precisely because it is the same everywhere in known space.

Short term perceptions of market behavior

In the financial markets, we often overrule our observations and our reasoning of fact with short term perceptions of market behavior. There is a widespread belief in the concept of the investment market’s Invisible Hand’, i.e. the market is all knowing and somehow prices securities correctly when no single or groups of investor(s) have the same opinion. Eugene Fama’s version which he proved using mathematics was his ‘Efficient Market Theory’. None of this is anymore than the belief than human beings ascribing unfathomable qualities to things we do not fully understand. Market pricing we say has its own rules and the market must be more right than those very few who actually do have a basic understanding of value. These few are called ‘Value Investors’. Warren Buffett is one of these. Buffett follows facts. Market pricing for the most part does not.

Facts of the Market: Earnings(generally so when not manipulated by deceptive mgmt), shareholder equity, numbers of shares outstanding, all actual counts or estimates of things sold, mined, shipped, consumed, amount traded, inflation, lending rates, numbers of individuals working or unemployed and etc, etc, etc. A long list- too long to list everything on which we actually perform a hard count in our economy.

Non-Facts of the Market: Stock and bond prices, consumer sentiment and PMI surveys, the relationships between things, i.e. inflation vs. stock and bond prices, i.e. Federal Reserve activity vs. interest rates, i.e. interest rates and the pace of business. This is also a long list and too long to enumerate.

You will notice that I place stock and bond prices in the Non-Fact category as I do the many currently accepted relationships between prices and any underlying factual measure. The price of anything is determined by individual perceptions of what something is worth vs. available options or expected options in the future. Prices are in their entirety ‘Market Psychology’. Prices are not facts. Prices change with perception of value and rapid run-ups and collapses in prices occur most often because of rapidly changing perception, not rapidly changing value. Price is pure market psychology. Price is what we think something is worth, not what it is worth relative to a fundamental benchmark. We often justify prices using a host of arguments which if examined closely violate common sense.

Market psychology: Price

Price is actually pure market psychology. Price is what we think something is worth, not what it is worth to a fundamental benchmark.

Once one begins to recognize the difference between corporate performance and what investors are willing to pay, one really begins to understand why so many stock and market forecasts fail. While one can measure corporate performance, one cannot with precision forecast what investors should be willing to pay as price is so deeply infused with ‘Market Psychology’. How investors feel about corporate worth varies across market cycles. Price is not the hard fact we treat it. Price cannot be used in mathematical analysis with any semblance of reliability and future predictability. Yet, we have used price as our major input for studying markets for more than 100yrs. Our major mistake is in thinking that prices as set by the markets are correct. This is the thinking behind our acceptance of “The Invisible Hand’ and Fama’s ‘Efficient Market Theory’. The concepts of ‘The Efficient Market’ and ‘The Invisible Hand’ fall apart when one’s focus is on fact and when one separates fact from non-fact. 2006 was when significant pieces began to come together for me, but early in 2009 was when the final pieces became one. That is why guidance based on fact has been so helpful since early 2009.

I have always had a ‘factual’ bias. It often leaves me out of the consensus. Fundamentally, the market is fairly priced today based using the SP500 Intrinsic Value Index.  But, the history of market psychology suggests we can see the S&P 500 (INDEXSP:.INX) hit $5,000+ over the next 5yrs-7yrs. The basis for this potential price level is our past 2 investment cycles. Hedge Fund Momentum Traders currently dominate market pricing. My research shows that Momentum Traders became a dominant market influence in 1995. They control a considerable quantity of capital especially when they use leverage. Hedge Funds now control $3Tril and with leverage could cause shifts of more than $6Tril+ compared to a global base of $60Tril. It has been their market psychology which has driven markets to excess levels in 2000 and 2007. What drove their belief in market valuation was an improving economy and the belief that markets priced stocks correctly. As long as the economy rises, I expect Momentum Traders to buy stocks and chase prices higher.

As long as the economy continue to show expansion, history says we should continue to witness rising stock prices ($SPY) ($.INX). The economic facts remain in positive trends. I expect stock prices to rise. The rationale’ of investing is to recognize and use both valuation analysis and market psychology to one’s benefit and know the difference.

Using A Science Based Approach to Markets via ValuePlays

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