The Evolution of Fear and Greed

 | Sep 09, 2017 | 10:00 AM EDT
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In recent years the biggest change in the market has been how the emotions of fear and greed function to affect price action. Those two emotions have always been at the heart of market movement and understanding how they work is what allows astute traders to produce exceptional returns.

For many years professional investors feasted on the emotional overreactions that were created by individual investors. They often went so far as to refer to these emotional amateurs as 'dumb money.' Acting contrary to the emotional wisdom of the unwashed masses produced great opportunities.

Fear and greed are still the foundation of market movement but the role they play has changed dramatically.

The nature of markets is to figure out what trading advantages and pricing inefficiencies exist. Traders gravitate toward the trades that exploit those opportunities and eventually there will be enough traders doing the same thing to wipe out the advantage that existed.

A good example of this is the well-known 'sell the news' tendency. When good news is anticipated, traders buy in anticipation so when the news actual does occur there is no one left to buy. The more the news is anticipated the quicker it is priced in and the fast any trading advantage is eliminated.

Over the past decade or so this thinking has been applied on a huge scale to deal with emotional reactions in the market. The programmers are aware of the tendency for there to be panic when there is bad news and they are also aware of the tendency toward overreaction. To exploit this they have designed computer programs that will automatically buy into weakness when it occurs.

Everyone in the market is now aware of this tendency toward buying dips. It doesn't matter what the news might be. We know the programs are going to eventualy kick in and the bounce will occur. Traders help to make it self-fulfilling because it has worked so well for so long.

One of the consequences of this is that the dips are shallower and much shorter lived. This market has not had a notable correction in a very long time because of this phenomena. Volatility has fallen to record lows because of the way that the programmers have tried to take advantage of movement caused by fear and greed.

This has confounded many market pundits who continue to think that fundamental factors will impact the emotions of investors and cause movement. That correlation is broken. Fundamental factors may trigger emotions but traders totally discount those emotions immediately. So when we have talk about North Korea developing nuclear bombs, the fear is immediately discounted.

The efficient market thesis stated that news is always immediately discounted so there is no advantage to trading. That has been proven incorrect in many ways but what is making trading more challenging now is that emotions are now being discounted even more efficiently. It is the emotions that have always given traders an advantage but now they are much more difficult to navigate.

Eventually this market is going to surprise the computer algorithms with a reaction that is not anticipated. When that occurs, it will create a cascade of reactions and provide some significant market drama. No one can predict when that will occur, but that is how markets always evolve. The efficient market makes a mistake and everything changes.

Fear and greed will never disappear but the way the market deals with them has evolved. Understand that and you will understand this market.

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