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Sentiment and Risk-Seeking/Avoidance Behavior

January 13, 2010

It seems as if a pattern is emerging that helps to synthesize a lot seemingly unrelated “anomalies” into one finely woven theory. I introduced “The Optimism Hypothesis” in the previous article: https://cssanalytics.wordpress.com/2010/01/10/sector-seasonality-and-the-optimism-hypothesis-part-1/  as an explanation for why certain sectors and seasons may perform better than others. Here is one excellent academic article  brought to my attention by Abnormal Returns http://www.abnormalreturns.com/2010/01/tuesday-links-short-suffering/  “Research shows that the returns to a momentum strategy is dependent on the state of investor sentiment.”  (SSRN). Essentially in this article, the author shows that Consumer Confidence is a major driver of relative strength strategy returns. When the consumer is optimistic, the winners beat the losers in grand fashion, when the consumer is pessimistic the reverse happens. Interestingly enough this helps to explain many of the empirical findings of my own research in this area which show that standard relative strength strategies perform best once a rally is well underway, and  poorly at extreme low points in the market.  

When I synthesize this information with my research on implied volatility, correlations, and volatility term structure, it becomes readily apparent that I am merely using diagnostic tools to measure the risk-seeking/avoidance behavior of the masses. Condor Options highlights a few academic studies expanding on sentiment measures http://www.condoroptions.com/index.php/financial-geekery/new-research-sentiment-expectations-and-stat-arb/ Several other measures and sentiment-based anomalies are worth noting: It looks as if Jeff of Market Rewind has already figured this out and uses  “Sentiment Spreads”–a composite score of the number of risky assets outperforming their most comparable peershttp://marketrewind.blogspot.com/2010/01/011210-rare-zero-sentiment-reading.html  as a valuable source of confirmation for trends intraday. As mentioned in my previous blog, it appears that there are strong seasonal tendencies in risk-seeking behavior that are in fact culminated in the form of higher estimate revisions and IPO returns as investors look forward to the first quarter of the new year. This tendency as well as the January effect probably mirror our own tendency to make New Year’s resolutions that are full of  hope and the promise of a fresh start. http://marketsci.wordpress.com/2010/01/07/marketsci%e2%80%99s-take-on-the-january-effect/Perhaps in a microcausm this is also responsible for the end of month/first of month effect as well. http://www.tradingtheodds.com/2010/01/how-to-make-millions-in-trading-the-spyder-seasonalities-i/ Further confirming this “optimism effect” are the strong seasonal tendencies surrounding the holidays and rising optimism prior to Fed days as people “hope” for a handout. http://www.tradingtheodds.com/2010/01/how-to-make-millions-in-trading-the-spyder-%e2%80%93-holiday-effects/When we look at market breadth– and its positive association with momentum/trend returns, again we are witnessing the same phenomenon of unified optimism. Several volume measures also seem to confirm the same effect in both directions– on the flip side in this study Rob at Quantifiable Edges confirms that low volume with a rising  SPY hitting new highs is a form of pessimism that is bad for short-term returns http://quantifiableedges.blogspot.com/2010/01/declining-spy-volume-at-new-highs.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+QuantifiableEdges+%28Quantifiable+Edges%29.

In general it appears that risk-seeking behavior is positive across the board for most types of feedback dependent strategies such as those that are momentum or trend-based.  This holds true only as  long as sentiment is not extreme. The same characteristics are true when measuring risk-avoidance behavior– negative in the short-term as long as it is not extreme. Many of the “anomalies” mentioned in the article (especially the momentum effect) are among the strongest and most persistent the market has offered over many decades. Noticeably absent in the very top echelon of alpha-generating strategies are the economic and balance sheet ratios that are the favorite focus of most insititutional asset management and brokerage firms. These areas are arguably the field where comprehensive and rational analysis dominates.

  It therefore stands to reason that the only real inefficiencies in the stock market are driven by the persistency of human beings to behave the same way over time and across economic regimes. We are the real constant force in the markets, and while its nearly impossible to outsmart eachother in rational times (or rational subject areas),we behave like lemming fools at irrational times–long enough to be taken advantage of by our more emotionally-balanced brethren.  As human beings our collective  moods are like the waves of the sea:  building slowly and reliably over long periods of time until reaching peak height in a few short yet powerful moments, only to collapse under its own unstable weight.The constant economic/stock market patterns of boom and bust will likely always persist until scientists can figure out how to change our primitive brains.

10 Comments leave one →
  1. Alex permalink
    January 13, 2010 10:45 am

    I think it’s partly human behavior and partly the nature of our economic system. Fiat money backed capitalism with asymmetric payoffs for decision makers results in excessive risk taking in the “short run” (1 year). Emerging industries and strongest stocks within those industries are white swans in (Taleb’s) “Extremistan” that really earn their name during bull markets. I guess the next question is how does one stay alive during rational periods? Mean reversion strategies?

    • david varadi permalink*
      January 15, 2010 1:24 am

      hi, i agree that the incentive systems in capitalism are also responsible for bubble behavior–this is an area that doesn’t receive enough blame for the credit crisis. i think the rational periods are somewhat random actually—think 2004–the mean-reverting periods are dominated by fear. great comments.
      best
      dv

  2. January 14, 2010 12:57 pm

    Hi Dave,

    Came across your blog while perusing the Abnormal Returns site today. Awesome stuff and glad to see and read that you are doing well and your “Super System” seems to be thriving in these volatile markets!!! You may also find the article link below interesting as it relates investing and poker:

    http:articles.moneycentral.msn.com/learn-how-to-invest/how-poker-makes-you-a-better-investor.aspx

    All the best,

    Jeff

    • david varadi permalink*
      January 14, 2010 2:09 pm

      hi jeff, thanks a lot! will definitely check out the link. certainly a strong relationship there between the two activities.

      best
      dv

  3. January 14, 2010 8:14 pm

    Excellent article DV.

    • david varadi permalink*
      January 15, 2010 1:20 am

      thanks wood! cheers
      dv

  4. Tastylunch permalink
    February 6, 2010 12:35 am

    ” As human beings our collective moods are like the waves of the sea: building slowly and reliably over long periods of time until reaching peak height in a few short yet powerful moments, only to collapse under its own unstable weight ”

    Sounds like you just rediscovered Elliot Wave Principle

    • david varadi permalink*
      February 6, 2010 12:45 am

      hi, i haven’t looked at that much–at some point it deserves some study for sure. it does seem like a wave-like principle captures sentiment.

      best
      dv

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