The Psychological Stages of the Japanese Crisis and Stock Selloff

Federal tsunami warning radios bleeped on at 1:40am Pacific time along the West coast of the USA last Friday morning.  The voice coming over the radiowaves reported an earthquake off Japan and gave a tsunami estimated arrival time in Santa Barbara at 8:24am and in Santa Monica at 8:39am.  This was the direct result of the largest earthquake to ever hit Japan, and the fourth largest to strike the earth in recorded history, now listed as a 9.0 on the Richter scale.

That morning TV viewers could see video coverage of a 30 foot wave washing over coastal villages in Japan, to such an extent that entire towns were lifted and crushed by the wall of water.

Given that Japan is the third largest economy in the world, you might think that U.S. traders and investors would rush to sell shares, buy puts, hedge, and reposition.

Nope,  by the close of trading on Friday, the DJIA was up 60 points.

It wasn't until Monday, and again today, that investors realized the full extent of the risks that had emerged.  "What took them so long," is a fair question to ask.  In this post I explain the psychological stages which drive financial markets after catastrophic events such as natural disasters and terrorist attacks.

Stage 1:  Underreaction.  In this stage people don't realize the scope of the disaster.  They believe the stock rally will go on as is, and they believe the government assessment of the situation.
Psychological Driver:  Cognitive Dissonance.  We have trouble processing new information that is out of our comfort zone.  We need time to reconcile it with our established habits and beliefs.

Stage 2:  Reaction.  We realize that all is not good, and we take action.  The Nikkei drops 14% in one day.  The S&P 500 sheds its 2011 gains.  This is occurring this week, probably up to Friday.  Fund managers sell the stocks of companies that are likely to be hit, and buy shares of those likely to benefit.
Psychological Driver:  Rational reappraisal.  We incorporate the new facts, and revalue securities accordingly.

Stage 3:  Overreaction.  This is where is gets interesting.  Uncertainty and fear color our assessment of the facts, and we believe we get more information from the market price action (plummeting) than from a rational appraisal of wind currents.  Stocks sell off, Potassium Iodide (KI) sells out off store shelves in California.  People sell their stocks just because others are doing so and prices are dropping, they don't want to be the last ones holding the bag.  This is the "risk-off" trade, where indiscriminate risk selling occurs.
Psychological Driver: Fear, uncertainty, and loss of a trusted authority.  Radiation cannot be seen, is widely feared, and may spread beyond Japan.  Perhaps most worrisome to investors, there is no longer a trusted authority who knows the truth - the Japanese goverment appears to either not understand the situation or to be trying to prevent panic by hiding the true impact of events.  All of these factors lead to overreaction - usually occurring about 4-5 days after a crisis, and culminating in panic, when real investment bargains are to be found.

If you're waiting to buy Japanese construction and insurance stocks, you might want to consider stepping in Friday morning.

And most importantly, our sincere condolences to all whose family, friends, or lives have been affected by this terrible crisis.

Richard L. Peterson M.D.
310.573.8523

Social Media Collective Wisdom Predicts Tech Stock Performance

"What Keynes recognized is that ... investors are concerned not only just with what the average investor thinks but with what the average investor thinks the average investor thinks. And the truth is: Why stop there? Maybe what you need to think about is what the average person thinks the average person thinks the average person’s view is."
-- James Surowiecki : The Wisdom of Crowds, p484.


At MarketPsych Data we've begun to analyze longer term predictive patterns in our social media data.  We've created indices that aggregate the perceptions of investors about companies and stocks expressed in their conversations, discussions, and (of course) rants in social media such as Facebook, Twitter, chat rooms, and blogs.

The index I'd like to discuss today is called "Innovation Perceptions" and it is self-explanatory.  Investors' perceptions of a company's innovativeness are measured using our proprietary linguistic analysis tools and then smoothed over time.  You can see the innovation perceptions of eight randomly selected (my personal brainstorm) tech stocks for the past decade (mid-1998 through Feb 1, 2011).  It's pretty fascinating on its own:

What's even better is when you run our backtesting software (developed for our hegde fund) on the data, and we see that the top one standard deviation of high-innovation tech stocks have a 10bps (0.10%) daily = 30+% annual outperformance of the rest of the tech stocks in our sample over 37,000+ stock-days.  Interestingly, the average tech stock outperforms the S&P500 by 10 bps daily since 1998:

In behavioral finance terms, this may be a sign of investor underreaction to the level of perceived innovation at a company.

The next step is to expand the sample size.  We'll continue to examine this effect and keep you posted.

Happy Investing!
Richard  Peterson M.D.
+1.310.573.8523
http://www.marketpsychdata.com/

ETF sentiment reads for Tuesday February 15, 2011

Overall our data is currently pointing to the upside trend continuing in the near term in the U.S. stock market - upwards price momentum is combined with solidly positive, but not excessively optimistic, sentiment.  That said, there are a number of interesting psychological trends we're seeing that present potentially good ETF trade ideas for the next one to two weeks.

The essence of our data is to measure crowd opinion and strong concentrations of sentiment.  When sentiment is extremely biased in one direction, we look for signs of reversal, and usually our clients will bet on an unraveling - that's their essential strategy.  Due to the characteristics of crowd behavior, most of the trade ideas below will naturally be contrarian. 

SHORTS
The ETF PBS (Leisure and Entertainment) is overextended to the upside.  Our data demonstrates high investor optimism which is coupled with recent price outperformance.  PBS may pause its recent run for a week or two and underperform the market.

KOL (Coal ETF) is likely to lag the market as well.  We're seeing very high levels of optimism coming off a strong bull move, which is a blow-off top scenario.  Due to the high optimism, it's likely to continue to underperform until investors adjust their expectations downwards.

Oil is likely to underperform over the next few weeks due to the investment community's concerns about Egyptian instability and associated fears and pessimism about oil supplies.  As the nervousness about Middle Eastern insecurity gradually resolves, the price of oil is likely to settle lower.  As a result, some Oil-related ETFs like IEZ are likely to underperform the market going forward.

LONGS
Biotech (IBB)  tops our "Most Hated" sector list for Monday.  Combined with its recent underperformance, it is set up psychologically for an upside move.  Over the past month we've seen a dramatic increase in our investor dissatisfaction scores in the Biotech sector.   Health care (XLV) is in a similar position.

Another one to two week long idea we have is in the homebuilders (XHB).  As you might imagine, we're seeing the highest negativity in this sector, and XHB tops our pessimism ranking.  While it may seem self-evident that investors are pessimistic about housing, we have observed that extreme levels of pessimism as we're seeing in the housing sector often precede a reversal. 

$MSFT is pessimistic going into earnings, likely to rise

$MSFT looking positively negative in advance of earnings tomorrow.  That's usually a sign of a post-earnings price rise.  We're good at calling post-earnings selloffs, as we did recently with AA, GOOG, CREE, and RFMD, so we'll see if the excessive pessimism on MSFT plays out to the upside as expected.

See the chart of the plumeting affection for MSFT:

High optimism in $RFMD going into earnings

$RFMD appears on our Top Ten Optimism list going into earnings.  That's usually a bad sign.  Unfortunately the stock is already down 4% today and more than that in the past week, so it's not a clear case of "buy on the rumor."  But we'll see soon enough.

Looks like our $GOOG short idea was right after all - I forgot to mention that in a "Buy on the Rumor" pattern it's often helpful to short at the open after the expected good news.  If the stock rises through mid-day, then time to exit.

Happy Investing!
Richard

Excitement building about $GOOG earnings tomorrow

$GOOG is going parabolic in the past few days on excitement over their upcoming earnings report tomorrow.  That usually spells trouble for the stock price in the short term.  However, $GOOG isn't a straightforward case of over-optimism - occasionally they have big disappointments, and occasionally big wins, so I wouldn't usually call this naivete.  The thing that makes me want to short it before the end of day is the amount of buzz from "noise trader" on online forums and chat rooms.  I'll post some charts of the enthusiastic buzz in a few hours.

$CREE sentiment showed distress among investors before 15% decline

After the earnings disappointment by $CREE after hours, and the fact it had been on our PsychTrades list as a short, I took a look at its Sentiment Alerts (summaries of investor conversations about the stock).  Looks like investors were suspecting fraud and were uncertain before the big disappointment.  See the chart below or at:  http://www.marketpsychadvisor.com/vitalsigns?ticker=CREE: