The Market Is Emotional

Last week the market crashed. This week the market crashed up.

A few points here:

·      This is clearly not a random walk. Fuck market efficiency.

·      Correspondingly, there is no rational reason for stocks to be worth 10% less one week, and 10% more the next week.

·      Clearly there were some crowded positions. Now we’re getting closer to the answer.

·      What is the cause of the crowded positions?

Emotions.

I like to make fun of CFAs a lot, and not just CFAs, but anyone who attempts to turn finance into a science, or treat it like a closed-form equation that you can simply just solve for x. No matter how sophisticated your spreadsheet is, no matter how many variables you have in your model, you cannot solve for x and get the correct price of something. It is not even going to get you in the ballpark, and the whole exercise is a complete waste of time. For two contemporary examples, let’s look at Nvidia and Netflix. Nvidia had a 75% drawdown. Netflix had two. You’re telling me that rational people with spreadsheets suddenly concluded that a stock is worth 75% less, and then 300% more? Give me a break. What happened was that people were overly enthusiastic, then fearful, then enthusiastic again. Gee whiz, maybe it makes sense to figure out when people are going to be fearful or enthusiastic. Maybe that is a better use of our time.

Now I am a guy who always says that if you’re doing something, and it works, then keep doing it. So if you are using fundamental analysis for your stock picks, and it is working, then keep doing it. You must be very good at it, or have some kind of edge that nobody else has. And that’s fine. I’m really talking about the armchair fundamentals that people do, like looking at the DES screen on Bloomberg and doing P divided by E. I’m not saying that my way is the only way. But what I might be saying is that even within your sophisticated fundamental analysis, there are some intangibles going on. There is a story. There is a narrative. There is a buzz. And don’t tell me that you aren’t influenced by the buzz. A hot stock has hype. And remember, it’s not enough to simply find a mispriced security. You need to find it first, and then you need other people to find it in order for the trade to work. The mispriced securities that don’t work are called value traps. There must be a story.

The best tool in the world for sentiment traders is journalism. The journalists are awesome—I love the journalists. Note that I did not say that journalists are dumb. They are clearly not dumb. But their job is to report on the news, and the stock market is newsworthy when it is really high, and it is newsworthy when it is really low, but not newsworthy in the middle. By the time that journalists get around to reporting on something, the trend is usually over. So yes, I read the financial news, but not in the way that you might think. The journalists report on what has happened, not what is going to happen. Fresh out of business school, I used to read The Wall Street Journal on the bus on the way to work. Now I read it on my computer in the morning, but for entirely different reasons. Now, I look for clues about sentiment. See what makes it on page 1, above the fold. In 2022, everyone was talking about European natural gas prices. Guess what we weren’t talking about three months later? European natural gas prices. Same was true for lumber. Same was true for orange juice. It works for politics and pop culture, too. Guess what we aren’t talking about a month later? The Trump assassination attempt. You are probably familiar with the phenomenon known as the “SI Jinx.” Back when Sports Illustrated was big, it was an open secret that when an athlete appeared on the cover of the magazine, their career was pretty much over. Works in finance and politics and pop culture, too. Once you see it, you can’t unsee it. Though the Hawk Tuah girl is still kicking around.

Twitter is fucking amazing. I love to see the types of people who succeed on Twitter. I’ll give you a hint: the people who succeed on Twitter are those who merely amplify the prevailing emotions. A good example of this is Anthony Pompliano, who tweeted every $1,000 price rise in bitcoin when bitcoin was going up. When bitcoin stopped going up, he became less popular. He’s far from the only one. Some accounts are good at tapping into what emotions people are feeling at that particular moment and magnifying it. People don’t like tweets that they disagree with. They like tweets that they agree with, naturally! I have a slow-growing Twitter presence because I am typically tweeting the opposite of what people are feeling at the moment. Cognitive dissonance results, though people are used to my act by now. To get an idea of current trends, take a shit on an emotionally charged stock or a token and see what kind of replies you get. That’s the primary benefit of Twitter in finance, is mining it for sentiment data. I am fond of saying that I’d rather give up my Bloomberg than my Twitter account. I don’t need to see prices and charts, I just need to see how you feel about the market.

One of the reasons investing is so hard is because it requires introspection.  You’re not just thinking about the market, you’re thinking about how you’re thinking about the market. And then you’re thinking about how you’re thinking about how you’re thinking about the market. Non-introspective people are typically not very successful. I think there are four characteristics of a successful investor:

1.     Intelligence

2.     Experience

3.     Emotional fitness

4.     Introspection

There are others, but those are the big ones. There are some successful dumb traders, but there is clearly a strong positive correlation between success and intelligence. Experience counts for a lot—hats off to the guy that has been cranking out returns for 25 years. The young guys may have a higher risk appetite, but they haven’t experienced a full cycle. And by the way, anyone under the age of 38 has not experienced a full cycle. And emotional fitness is probably the biggest one. The conventional wisdom is that as a trader, you’re supposed to be completely objective and unemotional. Bullshit. It’s impossible to be objective and unemotional. The key is to manage your emotions, and better yet, to play off the emotions of others. This is where the poker game comes in—you’re not just thinking about what hand your opponent has, but what your opponent thinks what hand you have, and so on. Layers upon layers of sophisticated reasoning.

One thing I’ve noticed about emotions in the market is that people generally don’t have memory of emotions in the market. They know how they feel right now, but they can’t remember what they felt like last week, last month, or last year. This is how people become alcoholics—they have complete amnesia about how bad the last hangover felt. I remember what the dot com bubble felt like. I remember the euphoria associated with it. I remember what the dot com bust felt like, the demoralization associated with it. I remember what the financial crisis felt like. I remember what the pandemic felt like. The one thing these episodes all have in common is that they are transitory. How you feel today is not how you’re going to feel a week from now, a month from now, or a year from now. This is true in general. If you are sad, you’re not always going to be sad. If you are happy, you’re not always going to be happy. This too, shall pass. The thing about trends is that they always, always come to an end. Even big bull markets in stocks. Even the big bull market in stocks that we are in right now. It will end, and then we will feel differently.

To win in the markets, you must be in tune with your own emotions. There are a lot of tough guy never-cry alpha male traders out there with their feelings and insecurities all bottled up that have a tough time of trading. Me, I used to cry at that Sarah McLachlan ASPCA commercial. If you are going to be a sentiment trader, you will have to have a high tolerance for pain, while you wait for the trade to work, and you have to be crafty enough to enter a trade in a limited-risk fashion. If you wait until the coast is clear, you will have missed out on a lot of returns. There is a quote: when it’s time to buy, you won’t want to do that. And when it’s time to sell, you won’t want to do that, either. The vast majority of people are excited by higher prices and demoralized by lower prices. That’s the way human beings are wired, and stocks are Giffen goods. You want to be the opposite—excited by lower prices and demoralized by higher prices.

If you want to be a successful investor, allow yourself to feel joy.  Allow yourself to feel pain.  Go see the chick flick.  Buy flowers for your wife for no reason.  You’re not a steely-eyed missile man.  You’re a human being, in a market full of human beings.  Be the wiser human being.