The Emotion Factor
Stockscores.com Perspectives for the week ending April 9, 2005
In this week's issue:
Market theorists argue that the stock market is efficient. By this, they mean that all available information is priced in to individual stocks, and therefore, no one can consistently beat the stock market since no one can consistently predict what information will be released by companies in the future.
The two assumptions of market efficiency are that how the information is spread from the companies listed on the stock exchanges to the public is fair, and, that investors act rationally. This week, I want to consider the second assumption of market efficiency; the argument that no emotion plays a role in investor decision making.
When I conduct the Stockscores seminars for investors, I often ask how many people in attendance have ever let emotion have a role in their stock market decision making. Typically, 90% of hands sheepishly go up admitting to the fact. Since some people are too shy to raise their hand, I can assume that virtually every investor has made an emotional stock market decision.
Most of us have sold a stock because we had a fear that it was going to go lower, or bought a stock because we felt like we might be missing out on a great opportunity to make money. We don't always make a rational decision about when to buy and sell.
The net result of these emotional decisions made by investors is that there is a collective emotional factor to the market, and that creates an opportunity because it represents a breakdown in one of the assumptions of market efficiency.
The emotional intensity of the market affects our ability to beat the market. The more emotion, the easier it is to earn market beating returns because there is a greater breakdown in market efficiency to exploit. This begs the question, what makes a market emotional?
The answer is a price trend. The emotional factor in the market increases when investors are consistently making or losing money over time because of a price trend. In an up trend, investors are happy and tend to judge fundamentals favorably, thus they perpetuate the up trend. In a down trend, investors are generally losing money and therefore fear lower prices, bringing an emotional influence to the stock market.
Where emotions are the least prevalent is in a sideways stock market characterized by complacency. As a result, a sideways, emotionless market is the hardest to trade, at least for the trader seeking to exploit emotional trading opportunities. Trends are short lived and whipsaws are common.
In an emotional market, the best traders are those who let profits run and don't get taken out of positions on minor counter trends against the primary trend. In a market lacking emotion, the trader finds the best success doing the opposite. Instead of seeking home run trades, the good trader in this market looks for base hits. Some times they even hope they get to take their walk to first base.
You have to adapt your approach to the emotional make up of the market. If volatility is low and prices are moving sideways, then seek to make trades that have smaller profits because price trends are much shorter. In a market where fear or greed have a dominant effect (a trending market), let profits run and don't ever trade against the trend.
Use the charts of general market and sector indexes to gauge the overall emotion of the market. Look to trade stocks where there is more emotion, but if you have to trade in a market that lacks emotional traders, be sure to adapt your strategy to take profits more quickly rather than trying to ride out longer term trends.
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For this week's strategy, I used the Sector Watch Tool. I noticed that the Sentiment Stockscore for the Pharmaceuticals sector was quite high (78), but I was also aware that the big Pharmaceutical companies like Merck and Pfizer had been beat up pretty bad in the last six months. I thought I would check the charts of the Pharmaceutical stocks that has a Sentiment Stockscore of 60 or better (using the US part of the Sector Watch tool) to see if there were some good charts that would benefit from the strengthening sector.
First, I checked the chart of the Pharmaceutical sector (.DJUSPR) on Stockscores, and found that it had rising bottoms (indicating optimism) and was testing resistance that has held up for some time. I also noticed on a one year chart that the longer term down trend had been broken, setting up a good reversal pattern for these stocks in general.
I then looked at all of the Pharmaceutical stocks that had Sentiment Stockscores of 60 or better, and found a few charts that are shaping up nicely.
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1. .DJUSPR
Notice that the long term downtrend has been broken and the sector is now making rising bottoms on the chart, indicating that optimism is returning to this industry. Resistance at 260 needs to be broken.
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2. MRK
MRK broke through resistance on Thursday, and looks like it wants to start to work on filling in the gap from late September. We may see the stock stall at the bottom of that gap, but the longer term sentiment for this stock is improving.
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3. PPCO
PPCO is hovering right under resistance at $13, and not trading with a lot of volatility. That is an indication that investors have confidence in the stock and the rising bottoms show optimism is picking up. Watch this stock for a breakout through $13.
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4. PFE
The long term downtrend on PFE was broken on Feb 18th, and the market has since been consolidating and forming a good rising bottom base. Resistance at $27.50 still needs to be taken out, but this chart is shaping up as a good long term bottom fish.
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References
Get the Stockscore on any of over 20,000 North American stocks.
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See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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