Sentiment Speaks: What If They Held A Recession And No One Showed Up? - Part II

For those that did not read the first part of this 3-part series, feel free to read it here:

Sentiment Speaks: What If They Held A Recession And No One Showed Up? - Part I

Market Sentiment

So, if it's not earnings or the Fed which are the invisible hands that direct the market, what does direct the market? Well, the answer is the collective “US.”

Back in the 1930s, a gentleman named Ralph Nelson Elliott discovered that the movements in the market are really a repeating fractal of overall societal sentiment which is governed by the natural law of the universe as represented through Fibonacci Mathematics.

As Elliott noted:

“Very extensive research in connection with . . . human activities indicates that practically all developments which result from our social-economic processes follow a law that causes them to repeat themselves in similar and constantly recurring series of waves or impulses of definite number and pattern.”

Elliott went on to further state:

“The causes of these cyclical changes seem clearly to have their origin in the immutable natural law that governs all things, including the various moods of human behavior. Causes, therefore, tend to become relatively unimportant in the long term progress of the cycle. This fundamental law cannot be subverted or set aside by statutes or restrictions. Current news and political developments are of only incidental importance, soon forgotten; their presumed influence on market trends is not as weighty as is commonly believed.”

Now, I want to tell you about a market prognostication made by Elliott back in the early 1940s. Let’s put ourselves back in that time period. World War II was raging around us, as the US was just entering the war at the end of 1941. And, the next four years saw some of the most horrendous fighting in world history. It truly was a period of ultimate negativity around the world. Yet, Elliott made the following prognostication at the time:

“[1941] should mark the final correction of the 13 year pattern of defeatism. This termination will also mark the beginning of a new Supercycle wave (V), comparable in many respects with the long [advance] from 1857 to 1929. Supercycle (V) is not expected to culminate until about 2012.”

For those who do not understand this, Elliott was forecasting a 70-plus year bull market while WWII was raging around him. This has to be the best stock market prognostication in history, bar none.

What did Elliott see that allowed him to make such a boldly accurate prediction?

Well, he recognized that the stock market was driven by waves of public sentiment. And that those waves of sentiment are fractally patterned. Therefore, as the market was striking a bearish extreme, it was time for it to turn in the opposite direction.

For those that want a deeper understanding of how we apply Elliott Wave analysis, feel free to read this six-part series I wrote for our ElliottWaveTrader and Seeking Alpha readers.

Contemporary Studies Supporting Market Sentiment As A Driver Of Markets

In fact, many recent scientific studies have since been conducted which support Elliott’s theories from almost 100 years ago.

Today, many mainstream market participants have begun to understand the market similar to Elliott’s perspective. During his tenure as chairman of the Federal Reserve, Alan Greenspan testified many times before various committees of Congress. In front of the Joint Economic Committee, Greenspan noted that markets are driven by "human psychology" and "waves of optimism and pessimism."

Ultimately, as Greenspan correctly recognized, it is social mood and sentiment that moves markets. I believe this makes much more sense when deriving the causality chain for market movement. And that's why more and more investors are now turning towards the study of market psychology to gain a better understanding of the market.

In a study performed by Dr. Joseph Ledoux, a psychologist at the Center for Neural Science at NYU, he noted that emotion and the reaction caused by such emotion occur independent and prior to, the ability of the brain to reason. This means that your primary decision will be based upon emotion, and only thereafter will your brain rationalize that decision.

In a paper entitled “Large Financial Crashes,” published in 1997 in Physica A., a publication of the European Physical Society, the authors, within their conclusions, present a nice summation for the overall herding phenomena within financial markets:

“Stock markets are fascinating structures with analogies to what is arguably the most complex dynamical system found in natural sciences, i.e., the human mind. Instead of the usual interpretation of the Efficient Market Hypothesis in which traders extract and incorporate consciously (by their action) all information contained in market prices, we propose that the market as a whole can exhibit an “emergent” behavior not shared by any of its constituents. In other words, we have in mind the process of the emergence of intelligent behavior at a macroscopic scale that individuals at the microscopic scales have no idea of. This process has been discussed in biology for instance in the animal populations such as ant colonies or in connection with the emergence of consciousness.”

In a 1988 study conducted by Cutler, Poterba, and Summers entitled “What Moves Stock Prices,” they reviewed stock market price action after major economic or other type of news (including major political events) in order to develop a model through which one would be able to predict market moves RETROSPECTIVELY. Yes, you heard me right. They were not even at the stage yet of developing a prospective prediction model.

However, the study concluded that “[m]acroeconomic news . . . explains only about one fifth of the movements in stock market prices.” In fact, they even noted that “many of the largest market movements in recent years have occurred on days when there were no major news events.” They also concluded that “[t]here is surprisingly small effect [from] big news [of] political developments . . . and international events.” They also suggest that:

“The relatively small market responses to such news, along with evidence that large market moves often occur on days without any identifiable major news releases casts doubt on the view that stock price movements are fully explicable by news. . . “

In August 1998, the Atlanta Journal-Constitution published an article by Tom Walker, who conducted his own study of 42 years’ worth of “surprise” news events and the stock market’s corresponding reactions. His conclusion, which will be surprising to most, was that it was exceptionally difficult to identify a connection between market trading and dramatic surprise news. Based upon Walker's study and conclusions, even if you had the news beforehand, you would still not be able to determine the direction of the market only based upon such news.

In 2008, another study was conducted, in which they reviewed more than 90,000 news items relevant to hundreds of stocks over a two-year period. They concluded that large movements in the stocks were NOT linked to any news items:

“Most such jumps weren’t directly associated with any news at all, and most news items didn’t cause any jumps.”

Now, if you are still not convinced, what if I told you that we would likely have the same general price movements even if market participants were locked away without access to news? You would think I was absolutely crazy, right? Well, read on.

In 1997, the Europhysics Letters published a study conducted by Caldarelli, Marsili and Zhang, in which subjects simulated trading currencies, however, there were no exogenous factors that were involved in potentially affecting the trading pattern. Their specific goal was to observe financial market psychology “in the absence of external factors.”

One of the noted findings was that the trading behavior of the participants were “very similar to that observed in the real economy.”

Not so crazy anymore?