At its core, the stock market is the study of human behavior. Investors and traders may use financial statements, pattern recognition and other tools but ultimately what determines how a stock performs is the emotional state and perceptions of the individuals that buy and sell them.
This focus on the foibles of human nature is summed up well in the dictum attributed to economist John Maynard Keynes: "The market can remain irrational longer than you can remain solvent." No amount of logical thinking can protect you from the strange things that humans do at times.
Our job as traders and investors is to navigate the price action the best we can and that often requires that we think like a psychologist rather than a mathematician or investment banker. We want to delve into the minds of people as they decide what moves they are going to make.
Here are three situations where the key to effective trading lies in thinking like a psychologist:
Earnings reports are mostly about expectations and how management manages them.
When Steve Jobs ran Apple (AAPL) he was well known for his low ball guidance. Apple would easily beat the published expectations, which produced positive headlines but traders would focus instead on the "whisper number." That number was always a bit vague but it became the benchmark to establish whether a report really was good or bad. Apple no longer plays this game but it illustrates the thinking that surrounds every earnings report. The question that always arises is whether or not it is a "sell the news" situation. Have market players already anticipated the news and fully discounted it or is this truly a surprise that will lead to further upside?
Some of the best opportunities come from chasing a stock that explodes higher on better-than-expected news. Typically, the market doesn't immediately discount the true value of an exceptionally strong report. Analysts will raise estimates and targets incrementally and many traders are hesitant to chase new highs. The greatest long-term investments usually have action of this sort at some point during their key growth phases. Stocks do not go up tenfold unless they keep making new all-time highs. Psychologically it takes a while to fully embrace what is to come.
If you buy in front of the news, earnings reports are just a straight gamble on expectations. The risk/reward ratio may actually be far better after the news is out and is being digested. The news itself evokes an emotional response and that response often is an overreaction. Jumping in when there are disappointing numbers is a trade that can produce exceptional results when expectations prove to be out of line with reality.
The great thing about earnings from a trading standpoint is that they are a catalyst for volatility. The reports produce a reassessment of valuation and while that is taking place we can gain an edge by focusing on the psychological reactions that develop
Federal Reserve Interest Rate Policy
This coming week the Federal Reserve is going to announce its interest rate decision and policy. This is one of the most anticipated events in the market in years and will be discussed endlessly.
Typically, Fed members do a pretty good job of indicating what is likely to occur. The Fed has a stated goal of transparency but fed Chair Jerome Powell has surprised the market several times in the last 7-8 months with a far more dovish stance than the market anticipated. When that happens, it produces extremely strong market responses.
The market is nearly certain that the Fed will cut interest rates by a quarter-point this coming Wednesday. There is a slight chance that they could cut by a half-point but they have already indicated that is unlikely. What is unknown is the level of dovishness that will be stated in the accompanying policy statement.
Since the Fed intentions are so well known it seemingly is a good setup for a sell the news reaction. In the current situation, the market has been anticipated this rate cut for many weeks. How can it not be discounted to a great extent already?
That is first-level thinking. However, human behavior is never that simple. If everyone expects the market to sell off on good news then it is less likely to do so because traders will compete to stay a step ahead of each other. Those that think the market will sell off on the news will have already sold and that makes for less selling pressure when the news is announced.
I'll be discussing the trading setup in the Fed news this week on Real Money. It promises to be a very entertaining and important event.
Another example of how psychology dominates trading action is presented by Beyond Meat (BYND) . The stock is closed Friday at around $235, which means it is up almost tenfold from its IPO price of $25 less than three months ago. The market cap of Beyond is bigger than many major food companies such as Campbell Soup (CPB) and there is no end to the comments about how outrageous its valuation is at this point.
I call this sort of situation, "Ponzi Scheme Trading" -- not because of the fundamentals of the company but because the focus of traders is on whether there will continue to be a supply of traders willing to pay even more. Ponzi schemes work because they create the illusion that there is an endless supply of buyers.
No reasonable person can conclude that the valuation of Beyond is justified at this point. The only reason that someone is willing to buy is that they believe that other people will be willing to ignore fundamentals arguments and pay even more.
What is fascinating about these sorts of situations is how long they can last and how far the stock can move. There is no way to know how long the dynamic that is driving this stock will continue. Beyond has earnings coming this Monday and management must be thinking about using this huge price premium to raise capital so a turn could come soon. For now, though, it is all about traders willing to bet on other trader's behavior.
There are endless examples of how psychology is used in trading. These are there basic examples that illustrate the thought process. Trading ultimately is about people and emotions and that is what makes it such an entertaining and lucrative pursuit.