How to Learn the Mood of the Markets
What is the most important driving force behind the stock market?
It’s not earnings or the Federal Reserve or politicians or great products or any of those factors that we read and hear in the financial media. More than all of that, the decision to buy or sell stocks comes down to one thing: are traders feeling fearful or greedy?
Fear and greed. There may be no more important goal for a trader than to be able to both master these emotions in yourself, and to recognize them in the words and behavior of others.
I have been told
by more traders than I can remember that trading is 10% technique and 90% psychology. And when it comes to trading, 100% of that psychology has to do with mastering sentiment. When traders are fearful, no price is low enough to pay for a stock.. And when traders are greedy, then no price is too high to pay for a stock.
Mastering your own fear will allow you to buy stocks when everyone else is panicking and afraid that the end of the world has arrived.
Mastering your own greed will allow you to take timely profits and avoid the incomparable pain of seeing winning trades become losing trades.
You may ask, if I am able to recognize these emotions in myself, then why should I bother learning how to recognize them in others?
Isn’t that just their problem?
Experienced traders measure sentiment, surprisingly enough, so that they can prepare themselves do to the exact opposite of what sentiment is telling them. Traders, for example, look for instances when sentiment is at an extreme, and then position themselves to take advantage when the sentiment switches and begins to move in the other direction.
In other words, when it comes to buying stocks, traders look for situations where the market is fearful, despairing and pessimistic.
And when it comes to selling stocks, traders look for situations where other market participants are displaying greed, overconfidence and complacency.
Magazines Measure Mood?
How do we know when traders are feeling fearful or greedy? There are a wide variety of factors and tools that traders use in order to try and figure out whether or not the emotions of traders have gone to one extreme or the other.
Some of these factors are commonplace and not easily quantifiable.
But they occur and are referred to often enough in the financial media that traders should be alert to them.
An example of one of the more popular factors is the so-called “magazine cover sentiment indicator.” Like its counterpart in the sports world (“The Sports Illustrated Jinx”), the magazine cover indicator refers to the fact that often by the time the mainstream media has developed a conventional wisdom about a giving topic
— for example, by displaying that topic prominently on magazine covers — that conventional wisdom or consensus has almost always run its course.
The most famous instance of this in recent times was the “Death of Equities” cover of BusinessWeek magazine from August 1979. At the time, the stock market was more than a decade into a long, grinding, sideways bear market. The mood of the country, in the phrase inaccurately attributed to then-president Jimmy Carter, was “malaise.” Despair and apathy were rampant and optimism
— toward stocks or anything else — was in extremely short supply.
It also happened to be a great time to buy stocks. By 1984, the Dow Jones Industrial Average was up more than 50% from the date the “Death of Equities” cover was published. Ten years afterward, the Dow was up by more than 200%.
You would be surprised at how bad the timing is in the mainstream media
— including the mainstream financial media. In their defense, much of the problem simply has to do with how the news cycle works.
Traders recognize that the media simply follows the news — and the longer it takes for a medium to determine what is most important to their readers or viewers, the worse that media’s timing will be. This is one reason why
— in the Internet age — traders still look to see who or what is on the cover of Barron’s or BusinessWeek on any given week.
It can be a great way of starting to measure the market’s mood.
Is the Internet or Cable News Any Better?
That said, do not believe for a second that the speed of the Internet and cable financial news makes them any more reliable sources of good sense and sobriety when it comes to the markets. As any one who has watched CNBC or Bloomberg or Fox Business News on a down 200+ point day in the Dow can attest, emotions move quickly from terror to elation, with reason often trampled under foot in the process.
These emotions can run so hot that many traders refuse to listen to the financial media during the trading day. After all, they have their methods and strategies already set and established. Why would something that popped into the head and out of the mouth of a cable news commentator matter more than the trading methods and systems that a trader has already tested and backtested a hundred times or more?
Other traders find the chatter on financial news programs to be as helpful as magazine covers
— and in exactly the same, contrarian fashion. By recognizing the fear and greed in the words and voices of those commentating on the market, traders are often able to recognize short-term extremes in emotion that can help them make timely decisions about when to enter
— or exit — a market.
There are other factors and tools that traders can use to measure market sentiment. These range from the volatility index and the put/call ratio, to more hard-to-quantify gauges such as the American Association of Individual Investors surveys and socionomics, the actual study of social mood. Each of these topics will be discussed separately in a forthcoming article from TradingMarkets.com. For now, know that emotions
— whether they are making you feel confident and strong or anxious and weak — are the enemies of sound, sober and successful trading. As a trader, conquering those emotions is the key step on the road to conquering the market.
David Penn is Senior Editor at TradingMarkets.com
You can find more how-to and educational articles to improve your investing
and trading each day on TradingMarkets.com.