Wednesday, December 10, 2014

The Perils of Short-Term Bias and the Importance of Feeding the Brain

Many observers of markets note the tendency toward "group think":  good ideas (and some not so good ones) catch on, eventually become consensus, and then become oversubscribed.  Here's an illuminating exercise regarding stock market sentiment:

I went back to 2006 and looked at the daily equity put/call ratio:  the ratio of puts to calls traded for every stock with listed options.  (Index options were excluded).  I then divided the observation into halves, based on high vs. low put/call readings.  When the ratio was in the upper half (more puts traded relative to calls), the next 10 days in SPY averaged a gain of  +.50%.  When the ratio was in the lower half (more calls traded relative to puts), the next 10 days in SPY averaged a gain of only +.03%.  It's been when traders and investors have been relatively bearish that we've seen the lion's share of broad market gains.

But suppose we look at how sentiment is related to recent, past price action.  When the put/call ratio has been in its highest quartile (most bearish), only 45% of stocks have traded above their five-day moving averages.  When the put/call ratio has been in its lowest quartile (most bullish), a little over 59% of stocks have traded above their most recent five-day moving averages.  

In other words, sentiment is sensitive to recent price action.  Traders and investors are susceptible to recency biases:  how markets have behaved over the last few days has impacted how bullish or bearish they are going forward.  (BTW, the correlation between equity put/call ratio and the proportion of stocks above their five-day moving averages is a statistically significant -.38).  The human tendency is to project the recent past into the immediate future--and that leads to substantially poorer near term returns.

How can we extract ourselves from short-term information processing biases?  One way is to make sure our thought processes are operating at a time frame greater than the one we are observing on screens.  Yesterday was a classic example for short-term traders:  we started the day with significant weakness, but small cap stocks notably could not trade to fresh multiday lows.  Indeed, my measure of monthly new lows showed that we had fewer new lows yesterday than during the prior decline early in the month.  As yesterday's post noted, when we see large groups of shares not participate in a market move, we have to question whether the move truly represents a sustainable trend.  It often reflects rotation within a range market. 

But we can't know that if we can't stand back from the time frame we're trading and see the larger picture.

Feeding the brain with big picture thinking is a great way of freeing ourselves from becoming slaves to the short term.  This is why I like reading well-assembled collections of links from astute market observers:

*  Charles Kirk posts "quotes for the day" in his service that are uniquely insightful.  I don't agree with all the perspectives offered, but almost all of those views are plausible and well reasoned--which helps me question my own thinking and not become locked in a single mindset.

*  Every day, Abnormal Returns is curating best content from the financial web.  A good example are his links from yesterday:  several reads ended up providing me with fresh perspectives.

*  Barry Ritholtz shares his daily reads, with a useful slant toward economics and markets.  Great to get inside the head of an experienced market observer.  

*  Reformed Broker Josh Brown shares what he's reading in the morning as his "hot links" of the day.  He finds great articles and research pieces as well, such as this one regarding income inequality during economic recovery periods.

If we're not operating at least one time frame above the one we're observing, our trading is likely to be more reactive than proactive.  Feeding the brain is a great way to avoid starving our trading accounts.

Further Reading:  Trading and Cognitive Bias