Practical Personal Investing, Session 6, presented by Greg Shtock 1

Market Psychology: Is the Market Rational?

Investors use sophisticated tools to analyze markets. However, there are always unexpected outcomes that cannot be predicted by simply looking at the fundamentals.

Behavioral Finance is the science which explains why market participants act contrary to rational market theory.

Dennis Gartman once said: “The market can remain illogical far longer than you or I can remain solvent.”

Supply and demand is the fundamental concept that determines the price in most markets.

However, this proven and rational method is NOT effective in determining stock prices.

Why?

Practical Personal Investing, Session 6, presented by Greg Shtock 2

Investors buy stocks in anticipation of their prices going up. Anticipation is an emotion involving excitement or anxiety. Do fundamentals or emotions drive the stock market?

Behavioral Finance studies the effects of emotional factors on economic decisions.

Technical Analysis studies price patterns that are affected by investors’ behavior.

Many times markets and stock prices move significantly up or down without any change in the fundamentals. The reason: change in investors’ sentiments.

The “Market” is a group of people acting based on their beliefs.

Therefore, emotions drive the stock market.

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We all know that we should be disciplined and rational. However, we act based on our emotions rather than logic. Why?

How many times have you thought that the market is irrational?

Former Federal Reserve Board Chairman, Alan Greenspan, often used the phrase “Irrational Exuberance” to describe the financial markets.

If emotions are bad, why do we have them?

Charles Darwin believed that our emotions help us survive, thrive, and avoid danger. When we are angry, we are likely to confront the source of our irritation. When we experience fear, we are more likely to flee the situation or threat. When we feel love, we seek out a mate and reproduce.

Emotions serve an adaptive role in our lives by motivating us to act quickly and take actions that will maximize our chances of success.

Example of an injured man who could not leave his bed.

Studies of human body energy and the brain function.

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The fight-or-flight response is a physiological reaction that occurs in response to a perceived harmful event, attack, or threat to our survival.

The autonomic nervous system acts unconsciously and regulates heart rate, digestion, respiratory rate, pupillary response, urination, and sexual arousal. This system is the primary mechanism in control of the fight-or-flight response.

During a threat to our survival, activities of non-essential organs, including our rational mind, are reduced. Blood flow is redirected to only the essential organs and muscles required to fight or to flee.

However, millions years of evolution has not provided our autonomic nervous system a plan on how to deal with modern stresses such as losing money in the markets.

Perceived threat and/or mental stress result in a similar pain level as if it were a real physical pain.

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Two people who are standing at different places looking at the same thing will see the same thing differently.

People raised in different cultures see things differently.

People of the same culture who have had different experiences while growing up will see things differently.

Example of two men and a dog.

Example of a basketball game. http://www.youtube.com/watch?v=vJG698U2Mvo

Every time you buy an investment, there is someone who has decided to sell it to you.

You have a good reason to buy; others have a good reason to sell.

Practical Personal Investing, Session 6, presented by Greg Shtock 6

Citi's Panic/Euphoria model has a pretty extraordinary track record of predicting returns.

It is a contrarian indicator, which means a “euphoria” signal is bearish and a “panic” signal is bullish. According to Citi, the model's components include “NYSE short interest ratio, margin debt, Nasdaq’s daily volume as % of NYSE volume, a composite average of Investors Intelligence and the American Association of Individual Investors bullishness data, retail money funds, the put/call ratio, CRB futures index, gasoline prices and the ratio of price premiums in puts versus calls.”

Currently, the model is dangerously close to euphoria territory, reaching its highest level since 2008. “The Panic/Euphoria Model is sending a clear warning sign of substantial complacency,” said Citi's Tobias Levkovich in a note to their clients.

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Definition of ‘Sentiment Indicator’

A graphical or numerical indicator designed to show how a group feels about the market, business environment, or other factor.

A sentiment indicator seeks to quantify how various factors, such as unemployment, inflation, macroeconomic conditions or politics, influence future behavior.

Investopedia explains ‘Sentiment Indicator’

Sentiment indicators can be used by investors to see how optimistic or pessimistic people are to current market conditions.

For example, a consumer sentiment index that shows pessimism may make companies less likely to stock up on inventory because they may fear that consumers will not spend.

Practical Personal Investing, Session 6, presented by Greg Shtock 8

The Consumer Sentiment Index is a consumer confidence index published monthly by the University of Michigan and Thomson Reuters.

The consumer confidence measures were devised in the late 1940s by Professor George Katona at the University of Michigan. They have now developed into an ongoing, nationally representative survey based on telephonic household interviews. The Index of Consumer Sentiment (ICS) is developed from these interviews.

The Index of Consumer Expectations is included in the Leading Indicator Composite Index published by the U.S. Department of Commerce, Bureau of Economic Analysis.

http://en.wikipedia.org/wiki/University_of_Michigan_Consumer_Sentiment_Index

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CONSENSUS Bullish Sentiment Index

The Index is intended to provide indication of potential market directions. The theory of contrarian opinion holds that when a predominant number of market analysts are bullish, it is quite likely that the market is approaching an overbought condition, and that a reversal in trend may be imminent.

CONSENSUS identifies the 75 percent level as the overbought level and the 25 percent level as oversold level.

The current reading is at 66%. See http://www.consensus-inc.com/hotline.htm

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The American Association of Individual Investors (AAII) is a nonprofit education publisher that has been successfully aiding “do-it-yourself” investors for over 30 years.

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Sentiment Survey Past Results

The sentiment survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market short term; individuals are polled from the AAII Web site on a weekly basis. Only one vote per member is accepted in each weekly voting period.

Reported Date Bullish Neutral Bearish

March 6 40.51% 32.86% 26.63%

February 27 39.69% 39.18% 21.13%

February 20 42.22% 35.00% 22.78%

February 13 40.15% 32.51% 27.34%

February 6 27.90% 35.70% 36.41%

January 30 32.18% 35.06% 32.76%

January 23 38.12% 38.12% 23.76%

January 16 38.99% 39.52% 21.49%

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Excerpt from Barron’s Magazine ( http://online.barrons.com/home-page)

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Book by Mark J. Douglas

Chapter 5 The Dynamics of Perceptions (page 70)

“If your goal is to be able to trade like the professionals, you must be able to see the market from an objective perspective, without distortion. You must be able to react without resistance or hesitation, but with the appropriate amount of positive restraint to counteract the negative effects of overconfidence or euphoria.”

Chapter 9 The Nature of Beliefs (page 138)

“Our minds are not naturally wired to be ‘objective’ or to stay in the ‘now moment.’ It means we have to actively train our minds to think from these perspectives.”

Chapter 8 Working with Your Beliefs (page 131)

The Fundamental Truths:

1. Anything can happen.2. You don't need to know what is going to happen next to make money.3. There is a random distribution between wins and losses for any given set of

variables that defines an edge.4. An edge is nothing more than an indication of a higher probability of one thing

happening over another.5. Every moment in the market is unique.

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Upcoming Events:

Next Webinar: Practical Personal Investing Webinars Series.Today webinar: Tools I Use.This is a real time demonstration of TC2000 program and how I use it to:=> Search markets for potential investments opportunities based on a pre-defined set of rules=> Manage portfolios and watch lists=> Set price and trend line alerts as part of your risk management plan=> Charts, technical analysis, regression channels, etc.=> Q&A session will follow this short presentation.When: Tuesday, November 18, 2014, 7 p.m. to 8 p.m.Where: https://join.me/InvestorsSupportNetworkWatch a two minute video “How to log in to the Webinar”Please Note. There is a $10 fee._____________________________________________________________________________________Next MeetingSubject: Investment Ideas for a Challenging MarketWhen: Sunday, December 7, 2014, 2 p.m. to 4 p.m.Where: Meeting Room #1 in North York Central Library, 5120 Yonge Street, Toronto, M2N 5N9. It is next to Mel Lastman Square, at North York station on Yonge subway line.Please note. There is a $10 fee.

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