How to Handle a Bull Market: The Psychology of Trading Volatile Stocks

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The U.S. stock market plunged on Monday, with the Dow Jones losing nearly 1,600 points at one point, the biggest single-day drop in its history. He then turned around and regained 567 points on Tuesday. What the rest of the week has in store for us is anyone’s guess.

Many pundits had been forecasting a decline for months after a protracted rally led to a string of record highs. Several factors are likely to have played a role. The Bureau of Labor Statistics’ January jobs report, released on Friday, was almost certainly one of them. This sparked concerns about inflation and bond yields, as well as fears that the Federal Reserve could raise interest rates faster than expected, events that may have “spooked” markets.

Markets translate the decisions of millions of people into a price for a stock or bond. Like a frightened crowd in a public place, investors sometimes tend to run in the same direction: let’s all play the lottery or flee the burning movie theater.

The work of visionaries such as Nobel laureates Richard Thaler and Daniel Kahneman has demonstrated that humans do not function as rational agents, as classical economics assumes. From this awareness emerged disciplines such as behavioral economics, neuroeconomics, etc.

Following the market ups and downs of the past few days, journalist Simon Makin spoke with neuroeconomist and psychiatrist Richard Peterson, managing director of MarketPsych research, whose most recent book, Sentiment-based trading: the power of minds in the markets, explores the role of crowd psychology in the pricing of securities, using an analysis of social media data on what underlies the violent highs and lows of trading.

[An edited transcript of the interview follows.]

What does yesterday’s market downturn say about the fickleness of market psychology and how people react when they perceive a threat to their wealth?
After a long period of no upheaval in the stock market, there has been an increase in perceptions of risk (or fear) in recent weeks. As prices rose it was not widely noticed, but once they started falling it triggered a quick fear reaction.

January’s sharp declines in bonds and speculative assets (like cryptocurrencies) likely sparked activity in [investors’] anterior insulae (part of the brain’s threat detection system). Once investors are emotionally primed by these losses, their emotional frame changes to look for other negative cues. Our brain begins to search the news for more negative information. When we find it, we feel threat and our amydgals are activated, comparing the current threat to memories of past threatening experiences. Shorter term traders then take action to preserve their highly leveraged gains.

We [MarketPsych] have evidence of this increase in pre-sale fear from the data we collected on media sentiment, using all references to fear – “worries”, “concerns”, “cautious”, etc. – regarding Nasdaq 100 stocks collected from 800 financial social media sites. The short-term average for this measure had been rising rapidly for about two weeks. This means investors were emotionally primed with fear, an emotion known to be correlated with declining bid and ask prices in Experimental Markets.

Social media wasn’t as prevalent in, say, 2008. Do you think that might have an impact on market volatility?
Yes, we see evidence of this in our data. Bubblemeter measurements [one of the barometers developed by MarketPysch to estimate market vulnerability] use net positive emotivity and expectations gathered from media output to indicate growing bubble risk. This shows that the level of speculative activity is skyrocketing – indicating bubbly and speculative language – and then reversing ahead of the sell off. This is more pronounced using only material from social media, versus news only, and tracks timing more accurately. According to our research, investors who survive on social media tend to be quite “wise” and more accurate than news media.

Does a day like Monday in the markets demonstrate anything about the rationality, or otherwise, of securities trading?
Yes, this shows that market movements can be irrational, reaching highs in previous months and now crashing sharply. In financial research, there are patterns called “overreaction” and “underreaction” to information. During uptrends, investors are said to react slowly (underreact) to the accumulation of good news. When there is a sell-off and the market rebounds later, investors would have overreacted to negative news.

Cognitively, it seems like investors process boring good news slowly, leading to an underreaction, but overreact to dramatic, snappy news (like sell-offs) setting the market up for a rebound.

The global economy is in very good shape, even though the markets seem to be at quite high levels. What is it about crowd psychology that causes people to overreact?
This is gregarious behavior. When we don’t know why prices are moving, we look to the behavior of others for direction. In this case, we look at the price movement as a proxy for others who know better, as an indicator of the knowledge they possess that we don’t. As prices fall, this creates a positive feedback loop – as we all sell, thinking others know best – that drives prices lower and lower.

Would you say that automated trading algorithms were involved?
Yes, but I don’t know to what extent. There are trend-following and volume-weighted execution algorithms that create exponential peaks and troughs in price. Beyond that, details are hard to come by due to industry secrecy.

Do you think this is the end of the “Trump Bump”?
In the long term, no, unless a new problem arises, such as a rise in bond prices. There is a bigger financial problem for Trump’s inflation and rising bond prices. He’s a credit guy and he likes to spend. It also has a history of spending itself in bankruptcy.

Does it have the same characteristics as other market panics?
No, it is simply a correction in the middle of a massive bull market. In fact, it’s healthy for the long-term bull market because it “kills the herd.” There is tremendous wealth and liquidity outside of stocks waiting to come back that could propel this market higher. We hope to be back in an era of higher volatility, which is generally healthier.

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