Wednesday, December 13, 2006

Stock Market Psychology: What You See Is Not What You Get

In my recent post, I showed how unaided perception of the market can be misleading. A market that looks as though it is rising over three different time periods ends up having worse near-term returns than an average market. Because of this, the naive trader--one who makes decisions solely based upon the appearance of a chart--is at an objective disadvantage relative to the trader who digs beneath appearance with careful analysis.

How about declining markets? Does a visual appearance of a downtrend alert us to future weakness, or is it a similar perceptual distortion when we extrapolate a negatively sloped line into the future?

Since 2004 (N = 734 trading days), we've had 134 occasions in which the S&P 500 Index (SPY) has been down on a one, four, and nine day basis. We could reasonably call this a short-term "downtrend". Four days later, SPY is up by an average .37% (84 up, 50 down), which is stronger than the average four-day gain of .08% for the remainder of the sample (330 up, 270 down). In other words, a market that is likely to be perceived as weak--down simultaneously across three time frames--has shown better returns than the average market.

Once again, however, let's extend our experiment. We'll pull out those occasions in which the market is down more on a nine-day basis than on a four-day basis and down more on a four-day basis than on a one-day basis. That creates our visual downtrend (N = 47). When the market looks as though it's in a steady downtrend, the next four days in SPY average a gain of .65% (33 up, 14 down), much stronger than the average market. Conversely, when the market is down over the three time periods but not in a visual configuration of a downtrend (N = 87), the next four days in SPY average a gain of only .21% (51 up, 36 down). In other words, the worse the market has looked, the better its near-term returns have been.

So let's summarize the results from the two experiments. Average returns over the next four days are as follows:

SPY up over three time periods and in a visual uptrend: -.11%
SPY up over three time periods and not in a visual uptrend: -.02%
SPY down over three time periods and in visual downtrend: +.65%
SPY down over three time periods and not in visual downtrend: +.21%

The naive visual trader who bought when the chart looked strong and sold when it looked weak would have lost consistent money. Conversely, the psychologically sophisticated trader who understood the limitations of human perception could have profited quite nicely. It is not paranoia to believe that the market systematically reallocates capital from naive hands to sophisticated ones: a process of natural selection every bit as ruthless as that found in the jungle.