Sunday, December 09, 2012

The Psychology of the Fiscal Cliff, Bullying, and the Impact of Stress on Markets

You have to remember one thing about the will of the people: it wasn't that long ago that we were swept away by the Macarena.
― Jon Stewart

Leading group therapy for mentally ill prisoners is never boring.  But is it dangerous?  Not really.  Humorous?  Yes, sometimes.  Enlightening?  Nearly always.  In one fascinating group, a mutiny against my leadership was led by a psychologically saavy gang-leader.

I bring up this experience because it mirrors the fiscal cliff drama playing out in Washington.  While I was confronted by a different league of bully in prison, the techniques I used to regain control of the group may be used in Washington to restore legislative momentum, and if we see them emerge, we will know compromise is near.

The mutiny in my group occurred minutes into our first group therapy event of the season.  Before we were more than two minutes into introductions, an intense young man stood up, look straight into my eyes, squared off before me, and loudly informed the group:  “He’s just some rich kid doctor from Santa Monica.  He doesn’t know %$#&@ about what we’ve been through!

I looked at him, knocked back by his outburst.  I protested, “No that’s not right…” 

He went on, “Let’s go guys, we don’t need this, we’re done with this &$#*&@.”  He walked out with his fellow group members, staring me down as they filed out of the room. 

I was left alone, embarrassed and befuddled.  After all, I was in fact a well-to-do young doctor from Santa Monica, and the fact that he – a powerful gang leader with an outside network - knew about my personal life was truly disturbing.  I needed professional advice about how to handle a situation like that one, so I turned to a wise mentor.

Negotiating with Bullies
“Democracy becomes a government of bullies tempered by editors.”
 Ralph Waldo Emerson

Bullies are part of our world.  While they are more common in prison, we all come into contact them in our lives, often at important times.  You might even say navigating bullies is an essential life skill.

The bully in my group therapy session had a long history of paranoia and violence, so it wasn’t too surprising that he acted the way he did in that first session. 

Fortunately a mentor of mine gave me useful advice on how to negotiate with bullies such as this prisoner.  When I used his advice, I regained control of the group and the gang-leader turned out to be a terrific ally

I’ll share the advice later in this letter, but first, we’ve got a few more weeks of bullying to witness at the highest levels of the U.S. Government.  After the fiscal cliff comes the debt ceiling negotiations in January, so the drama is likely to continue.  First we’ll look at data on how Stress and Uncertainty affect markets.  Understanding the negotiating strategies and psychologies of the two parties will give us a sense of how the talks are likely to pan out.  And we’ll then review the sentiment trades from our last newsletter and add a couple for this week.

How Stress and Uncertainty Affect the U.S. Stock Market
As investors, we need to know how the fiscal cliff will affect equity prices.  Obviously there are a range of sentiments aroused by the political brinksmanship, so analyzing one sentiment isn’t a perfect proxy.  That said, we think our variables Stress and Uncertainty from the Thomson Reuters MarketPsych Indices are a fairly good proxy for what investors are experiencing.
As you can see in this dramatic plot of Stress in news reports about the S&P 500 and its constituent companies, Stress (blue line) is at a 12-month high.  Social media shows a similar spike in the last month, but it is less dramatic (in social media August was the most stressed month).

We performed a quick cross-sectional analysis in which we looked at 40 ETFs tracking the largest indexes, sectors, and industries in North America with high Buzz (lots of chatter) in financial social media over the past 14 years (1998-2012).  We sorted those ETFs by the percentage of that chatter that was Stress-related.  The past 24 hours of Stress was aggregated to 30 minutes before the close today (t) was matched to the percent return from today’s Close to tomorrow’s Close (t+1).  For each Quintile of Stress days – the highest Stress 20% of days is on top and least Stressed 20% is on the bottom – we averaged the one-day forward return of that ETF. The sample included data from 1998-2012 but largely centered on 2008-2012 due to a higher number of ETFs being available for analysis over that period.

One Day Forward ETF Return
Highest Stress
Middle Quintile
Lowest Stress

In the case of Stress, high Stress precedes high return days.  In fact, if this Quintile strategy were tradable (assuming unrealistic zero transaction costs, optimal portfolio formation, a lack of overfitting, etc…), we would see over 30% average annual returns.

While the quintiles tell an interesting and potentially lucrative story, the deciles are even more interesting:
One Day Forward ETF Return
Highest Stress







Lowest Stress

It looks like greater than 50% average annual returns from this strategy, but I want to be clear that THIS IS NOT TRADEABLE as it is.  The extreme stress days are better at timing reversals.  When many ETFs are hitting extreme stress points at the same time, there tends to be a positive price bounce.  This is a specific timing model, not a portfolio rotation-type model.
But while we’re at it let's take a look at Uncertainty.  With Uncertainty we don’t see high daily returns. 

One Day Forward ETF Return
Highest Uncertainty
Middle Quintile
Lowest Uncertainty

Interesting about Uncertainty is that the higher returns occur for both high and low states of Uncertainty.  When Uncertainty is low, markets rise (a little).  When Uncertainty is high, they also rise (a little).  In a subsequent newsletter we’ll look at the effect of Uncertainty on prices more specifically, especially how it can be used to profit when seen as an amplifier of sentiment signals.  But more on that later…

To understand how the uncertainty and stress of the fiscal cliff negotiations is likely to resolve, it helps to revisit my negotiations with prison bullies. 

Prison Therapy

The bully who challenged me in prison felt he had the moral high ground and that because of my presumed background (rich doctor), I was less than human.  He usurped my authority to complete his own agenda – getting more physical and economic power among peers. After my first losing encounter, the wisest psychotherapist I know, who is a mentor of mine, told me how to work with him.

I was to hold the group again and invite the bully.  According to my mentor, when the group started the bully would again express contempt towards me and attempt to split the group from me, earning him additional political points.  My job as therapist was to remain in a curious state of mind and to aggressively and preemptively call out the bully’s behavior. 

First of all, when the bully denounced me and prepared to walk out, I was to immediately and calmly say, “I think you’re going to leave now.”  He couldn’t do what I said he was going to do, as my predicting his behavior undermined his dominance.  He would then have to stay in the room to re-establish his dominance before leaving. 

Then when he said, “you just don’t know anything about our lives!”  I would respond, “you’re right, I don’t know how hard it is to be you, so tell me, what’s it like?”  When he said, “you’ll never understand,” I was to respond with sincere interest, “Could you help me?”  When he looked frustrated, I was to say, “I get that you’re angry, and you want to leave” again preemptively calling out his behavior. 

As I acknowledged his position, he HAD to respond in order to stay dominant.  But as I drilled in further with genuine curiosity, he couldn’t escape.  As long as I was persistent, authentic, and didn’t back down, eventually he would be forced to either answer my questions (and thus engage in therapy) or he would be forced to again leave the group but this time but in the weaker position.

Our interaction played out exactly as above, and to make a long story short, in that second session he engaged in therapy.  Later that week he became the group’s greatest promoter, rounding up all the group members to attend every session thereafter.

But this newsletter isn’t about group therapy in prison.  Of greatest relevance is how the fiscal cliff is likely to unfold as two parties of bullies bump heads.

What is Likely Outcome of the Cliff?
“In politics, stupidity is not a handicap.”
― Napoleon Bonaparte

It’s no secret that both political parties feel they have the moral high ground, and they think of their opponents as something less than human.

Media hype about the potential catastrophe of failed fiscal cliff negotiations is unlikely to move Democrats and Republicans, because each side essentially has its own media.  One might think that a sharp fall in equity or rise in bond markets might get politicians moving.  But then, recall that the first financial bailout failed in the House on September 29, 2008, after a severe selloff had already occurred.  The Dow subsequently dropped 700 points intraday on September 29, finally spurring compromise. 

That said, a compromise is likely, but before any compromise is possible, we’re going to see one side in the negotiations aggressively and empathetically calls out the other’s actions (as I did with my bullying gang-leader client).  For example, Obama may tell Republicans, “I get that any pain you feel now, you’re going to make up for it in January by blocking me at the debt ceiling talks.  As it is now, you’d prefer not to make a deal with me, so we’re going off the cliff.”  And Republicans saying, “We understand you’ve got us in a trap, that public opinion is against us, and you’re going to push through a tax increase on the rich at any cost.”  For Republicans, this has begun to occur, but is not uniform from their side yet.  What is remarkable about this process is that the authentic side will usually win – they will get more of what they want in January.   I would say that Obama tried this previously and was rebuffed, but now he is in the position of the group leader, and could get more traction (and have a much easier second term).

Whatever happens, I suspect the stock market rallies in 2013.  Cooperation between the parties would lead to a greater rally, and continued resistance to a lesser one.  But my opinion is that the next two months we will see enough Republicans cross the aisle to break the logjam in Washington.  Maybe that’s overoptimistic, but if we see that, the equity markets will like it. 
That said, the overall investor mood is much more pessimistic than mine.  The chart below shows the Outlook (Optimism – Pessimism) in social media around stocks in the S&P 500.  As you can see, the overall pessimism level is near that of 2011. 

When we look at which industries are the most disliked, we see that retail, consumer services, and internet are on top.  It looks like investors are preparing for spending cuts, and these industries will be most adversely impacted by any recession or reduced consumer activity.

In fact retail and consumer industries are the ones to buy in case the fiscal cliff looks near resolution (without significant spending cuts).  And even if the spending cuts are drastic, the impact looks to be factored in already by investors. 

How Do I Safely Drive Over the Cliff?
“Just because you do not take an interest in politics doesn't mean politics won't take an interest in you.”
― Pericles

The truth is that the fiscal cliff may not be as bad for the markets as hyped in the media.  In fact, the U.S. dollar and the bond market may rally if all tax hikes and spending cuts take effect. 

There are many considerations when preparing for the fiscal cliff, and it’s better to consult a financial advisor about your specific needs.  For example, given that capital gains taxes are set to rise, you may want to sell more stocks this year to book the profits both for tax reasons and to avoid any year-end market decline driven by others doing the same thing.  But such preparations are very complex and are out of the scope of this newsletter.

If you are a financial advisor, please subscribe to our financial advisor newsletter that discusses how to speak with clients to help demystify the cliff.

We personally recommend increasing U.S. equity exposure on any fiscal cliff-induced selloff, and we expect that retail stocks will have the biggest bounce after resolution given what we are seeing in social media.

Trading Recap

Trading recap from last newsletter:  Our short on Nokia (NOK) yielded 8% as the stock fell from its short-term high for the week.  Our buy on Diamond Foods (DMND) was also profitable, as that stock rose 8% over the week.

Week ahead:  We're seeing a one-week buy on Intel (INTC) with high negativity and a sliding stock price over the past quarter.  Fundamentally INTC is a bargain with an 8 P/E and a dividend of 4%.  We’re also seeing a one-week buy on Freeport McMoran (FCX) following a large decline after $20 billion in buyout offers were floated this week.  The stock is likely to rally slightly as investor opinion turns less negative from the initial reaction (See Disclaimer below).

Stay tuned for our yearly forecast at the end of the year, where we profile the most optimistic and pessimistic equities of the year with expected underperformance and outperformance respectively.  Our track record looks reasonably good this year with our 2011 picks panning out as expected, such as our short on McDonalds (MCD).

Hosuekeeping and Closing

We recently launched the Thomson Reuters MarketPsych Indices for monitoring market psychology for 30 currencies, 50 commodities, 120 countries, and 40 equity sectors and industries in social and news media.  In subsequent weeks we’re going to have interesting charts related to global macro sentiment trends as our new data is plugged into our internal visualization software.

We love to chat with our readers about their experience with psychology in the markets - we look forward to hearing from you!  We especially love interesting stories or your or others experiences.

We have speaking and training availability.  Please contact Derek Sweeney at the Sweeney Agency to book us: [email protected], +1-866-727-7555

Happy Investing!
Richard L. Peterson, M.D. and The MarketPsych Team

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