Stock Exchange: Can Psychology Be Applied To Market Behavior? – Seeking Alpha

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Our Stock Exchange is all about trading. Each week we do the following:

  • Discuss an important issue for traders;
  • Highlight several technical trading methods – including current ideas;
  • Feature advice from top traders and writers; and,
  • Provide a few (minority) reactions from fundamental analysts.

Our goal is to be both educational and fun. We welcome comments, links, and ideas to help us make this a great resource for traders.

Review

In our last Stock Exchange, we asked whether you should buy the rip or the dip. If you missed last week’s edition, check it out.

This Week— Can Psychology be Applied to Market Behavior?

This great topic has attracted recent attention from the experts we follow.

Trading Tips

Dr. Brett Steenbarger, whose imagination continually creates new ways to view the evidence in front of us, challenges us to consider the psychology of the market. This is sharply different from the normal focus on the psychological challenges to the individual trader. Brett writes:

When we think of trading psychology, we typically think of the psychology of the trader and the factors that either contribute to or distract from a peak performance mindset. Another facet of trading psychology is reading the intentions of other market players. This is very similar to psychology in poker. The mindset of the poker player is important, and it is also important to read the psychology of the other players at the table. The skilled poker player reads those tells from other players to infer if they are bluffing or if they might be holding the nuts. When short-term trading/market making occurred on the trading floor, reading the other participants in a market truly was more like reading other poker players. With most market activity being electronic, we need other ways of inferring the intentions of market participants.”

Michael Batnick has an interesting post about experience. One feature is a story about famous hedge fund star Stanley Druckenmiller – why he got a big promotion, leapfrogging eight more senior people:

…the reason he was given that position was because he didn’t yet carry the burden of experience. When he asked why he was promoted above the others around him, his boss said, ‘For the same reason they send 18-year-olds to war. You’re too dumb, too young, and too inexperienced not to know to charge. We around here have been in a bear market since 1968.’ This was 1978. ‘I think a big secular bull market’s coming. We’ve all got scars. We’re not going to be able to pull the trigger. So I need a young, inexperienced guy to go in there and lead the charge.”

His conclusion is that experience is overrated. I disagree. The real challenge for asset managers is to draw upon experience while avoiding human frailty.

Let’s turn to this week’s recommendations from our group. They were all eager to put Brett’s poker advice into action, but we did get a few comments.

Expert Picks from the Models

This week’s choices cover a wide range, from energy to financials, to tech. There is something for everyone.

Road Runner: I recommended Netflix (NFLX) in my first appearance on the Stock Exchange. In late March of this year, it had come off of recent highs and reached the bottom of its 6-month channel. I happily held the position as it appreciated through this spring, selling at some point in late May. Now, I think a re-entry may be appropriate. Let’s review the chart:

The collapse of this stock, beginning in June, took it from the very top of its channel to the very bottom. We’re below the 50-day moving average, but not yet close to the 200-day moving average. Further significant declines are unlikely, and there is significant upside.

J: It is always interesting to revisit a trade we have held before. This stock has also attracted attention from one of our trading experts, Adam H. Grimes.

RR: And does he see what I do?

J: Almost. He notes the decline and potential rebound. He is not quite ready to pull the trigger.

RR: If he had spent some time being chased by that crazy coyote, he would move faster! Beep, beep.

Holmes: Range Resources (RRC) declined after a small rally last week. This is typical of stocks providing a good entry opportunity.

The stock showed some life after a patchy decline since mid-April. At its current price of $23.18, it is well below both the 50-day and 200-day averages. I am looking for a rebound to these points. With a PE of 18.6 the stock is also attractive on the fundamentals.

J: It looks like a consistent downtrend, along with the rest of the energy group. The price of oil looks stuck under $47 per barrel.

H: I am not trading oil. Whatever is happening in that market, this stock is showing attractive relative strength.

J: Have you been following the OPEC news?

H: You know well that I do not read news — just charts.

Felix: Micron Technology (MU) is my pick for the week. It’s a good bit sexier than my usual selections, but I have a good reason for it! Look at the chart:

Growth over the past year has been significant, and most importantly, it has been steady. Outside of a jump in mid-May, we’re seeing steady rises in stock price – reflected by the modest curves on the moving averages. I like that the stock has tumbled a bit this month. I’ll gladly take that as a buying opportunity.

J: This morning the pundit-in-chief opined that many people, focused on the stock symbol, thought it was some type of animal rights stock.

F: Who cares? It does not matter. Traders do not care what the company does. We succeed by identifying and exploiting the flow of trades. That is what I have done. What is this company anyway?

J: A chip stock.

F: So! It is in the food group!

J: Not that kind of chip; a semiconductor chip.

F: You should be more precise in your language.

J: Do you have updated ratings?

F: Of course. My fans have made some new requests. My assistant is supposed to respond to all of them.

J: Your assistant? I didn’t see any new additions to the payroll.

F: Oops. Here they are.

Athena: Discover Financial Services (DFS) is an interesting pick after a possible new uptrend. DFS saw a high upward run in the last two months of 2016 trading into the 70s from about 57.50 in early November. The stock had a fall into the higher 60s territory in January this year. The past prices illustrate the market view of potential value. The recent basing signals a possible bottom.

J: Nice to see you back on the job! You understand that part of your vacation was unpaid.

A: Unlike human traders, I do not force it when nothing is there. That shows up in my long-term results.

J: I really do understand that, and I hope your vacation was refreshing. Turning to DFS, haven’t we discussed this stock before?

A: Not from me, but perhaps one of the others…

Holmes: Yes, I bought the dip in late April.

J: How did that work out?

H: Not well, as you certainly know. Please keep in mind: My batting average is above .500 and the winning trade size is much greater than the losers. My trading discipline helps me to avoid big losses. Small losses are just part of the game.

J: Thanks for explaining. You have indeed done well on limiting losses.

Oscar: I do not have a new sector this week.

J: That is a disappointment. Everyone is talking about a possible change in market leadership. The story is that all of the gains come from a few stocks. Why don’t you own those?

O: That general impression is completely wrong. Lawrence Hamtil looks at market leadership over the years. Most people would be surprised.

J: A very interesting article. How did you happen to see it?

O: Someone took my sports section.

J: An honest answer. Did you analyze the sectors requested by your fans?

O: Yes. This week’s list includes everything that has been requested.

J: An astute reader asks about TLT and TBT. You list both in the sell range. Since these are inverse holdings, how can both be a sell?

O: The rankings in the sell range do not imply a recommendation to “short” the group. They simply have very low ratings when other choices are much stronger. I would sell either one for a better opportunity.

J: Thanks for clarifying. You are basically saying that bonds are not a good choice – either long or short.

O: Exactly.

Conclusion

Psychology is a part of trading. Technical analysis, as Dr. Brett explains, is a way of reading the psychology of the market.

This week, a member of our analytical team was having trouble finding the Road Runner trading channel. He opined that the model seemed to be wrong. This is the human psychology question in a different guise. Our answer is very clear:

The model is not wrong! You are. It is based upon thousands of objective cases. If it does not look persuasive to you, grasshopper, you need to change your perspective.

After many years of looking at model charts and recommendations, I treat them as wise, but silent, advisors. In the Stock Exchange series, I try to make great advice come to life.

Here is a summary of the cast of our characters. Find your own favorite!

Stock Exchange Character Guide

Character

Universe

Style

Average Holding Period

Exit Method

Risk Control

Felix

NewArc Stocks

Momentum

66 weeks

Price target

Macro and stops

Oscar

“Empirical” Sectors

Momentum

Six weeks

Rotation

Stops

Athena

NewArc Stocks

Momentum

One month

Price target

Stops

Holmes

NewArc Stocks

Dip-buying Mean reversion

Six weeks

Price target

Macro and stops

RoadRunner

NewArc Stocks

Stocks at bottom of rising range

Four weeks

Time

Time

Jeff

Everything

Value

One month or long term

Risk signals

Recession risk, financial stress, Macro

Background on the Stock Exchange

Each week Felix and Oscar host a poker game for some of their friends. Since they are all traders they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check it out for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present, and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.

Getting Updates

We have a (free) service for subscribers of our Felix/Oscar update list. You can suggest three favorite stocks and sectors. Sign up with email to “etf at newarc dot com”. We keep a running list of all securities our readers recommend. The “favorite fifteen” are top ranking positions according to each respective model. Within that list, green is a “buy,” yellow a “hold,” and red a “sell.” Suggestions and comments are welcome. Please remember that these are responses to reader requests, not necessarily stocks and sectors that we own. Sign up now to vote your favorite stock or sector onto the list!

Disclosure: I am/we are long DFS, RRC, NFLX, MU.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.