Monday, February 04, 2013

Buy to the Sound of Cannons: The Relationship Between Global Violence and Asset Prices

"Buy on the sound of cannons, sell on the sound of trumpets"
~ Nathan Rothschild, 1810

Maybe you haven’t heard the above quote, but you’ve certainly heard this variation with the same meaning - “buy on fear and sell on greed.”

Easy to say, hard to do.  It is far more comfortable to speak those words in a lecture hall than it is to execute on them during a civil war.  And as we’ll see below, it is not always sage advice, especially in the case of currency trading.

Fear is one of our oldest emotions.  First we must nourish ourselves to live.  Second we must avoid danger in order to survive.  The biological fear response saturates our bodies and brains with hormones and neurotransmitters and throws our rational prefrontal cortex offline.  In the midst of fear, our breathing, heart rate, circulation, muscle tone, digestion, and sensory interpretations all change.  As our fear prepares us for fight, flight, or freezing, it creates an involuntary physiological response that we have little conscious control over.  Fear turns our bodies into unthinking survival machines

I like the cannons in the opening quote because the fear that war and violence cause are significant to our predictive models for countries and currencies.  It is difficult to measure expressions of fear in the news – reporters are trained not to express their own emotions.  But they can report on the images and interviews that stir fear in them, and those interviews are usually around the topics of violence, chaos, and social breakdown.

Last newsletter we introduced the idea of buying stocks in countries with the greatest government instability as reported in the news flow.  In this newsletter we introduce a full model of global equity investing.  First we describe our automatically updating global investment risk map.  Towards the end of the newsletter we identify the sentiments that are most influential over currency prices

We’ll be in San Francisco on February 13th for a company meeting.  If you’re interested in learning more about our company, please get in touch.

Global Investment Model
Last newsletter we profiled several sentiments that, when aggregated from the news flow about a country, appear predictive of future stock index returns in that country.  We (and by “we” I mean Changjie Liu, MFE) did additional work on these variables. We found that all of the profits on the most impactful negative variables, such as GovermentInstability, come from long positions.  However, the short positions significantly dampen volatility, especially during 2008.

When we controlled for developing vs developed status of nations, their past stock index returns, and GDP, we found that most of the sentiment factors continued to demonstrate independent predictive power.  Given such controls, we selected the most stable and top-performing Thomson Reuters MarketPsych Indices for a final model of global investment risk.

The hypothetical equity curve of our final model, excluding transaction costs and demonstrating daily volatility, is below.  As you can see, it’s not perfect, but it is interesting:

This model was not generated via rigorous backtesting, because the averages are too long and the sample sizes too small.  So please consider it with that caveat in mind.  Using the above model we mapped the rankings using our data through January 2013.  The result is below, followed by the list of countries and their rankings using our models.  According to the model of the 20 most-discussed countries in the global news flow over the past 12 months, Russia and Mexico are predicted to have high-performing stock indexes in 2013.

Grey countries did not have adequate Buzz to appear in our models this year.  For a view of the ranking in a table format, see below:

If a short offset is desired against the Mexico/Russia exposure, shorts on Ireland and Brazil could be placed.  Keep in mind the shorts are for dampening volatility.  We don’t see excess returns from the short side of the ranking.

What Drives Currency Valuations?
From our latest research into currencies, we are seeing two fear-based sentiments in the news flow driving currency returns:  Uncertainty and Violence.  The uncertainty reflects doubts about interest rates and monetary policy in the country of interest.  The violence is related to war-like events that impact the currency price (wars, assaults, terrorism events, etc…).

Using a study protocol similar to that we used for Countries – selecting the prior 12-month’s top 8 currencies by chatter volume (GBP, EUR, CHF, JPY, AUD, etc…) and then going long the top 2 and short the bottom 2, we see significant outperformance when arbitraging currencies based on Uncertainty and Violence.  The U. S. Dollar was removed from this study, since it is the other side of all the currency pairs used.

Uncertainty is fuel for fear, and in the case of uncertainty, investors should buy currencies with high uncertainty and go short those with low uncertainty.  

Importantly the case of violence is NOT contrarian.  Investors should short currencies with high associated violence and buy those with low violence.  

Our currency research is ongoing, and we will likely develop a model in the same fashion as that we developed for countries.

Trading Recap
Our medium-term long on RIMM from November 4, 2012 should be closed out now.  There was a classic Buy on the Rumor, Sell on the News price move around the Blackberry 10 release.  This price pattern is a personal favorite of mine, and my 2002 academic paper on the topic is one of the few to examine its psychological origins.  In any case, time to close out now with a 48% profit.

Of our one-week trades from the January 5, 2013 newsletter:  the short on TAN (solar ETF) lost 3% and Buy on Nike (NKE) gained 1%.

Going forward, we have a one-week short on SWIR (Sierra Wireless Inc.) due to over-enthusiasm about a sale of their air card business.   We have a one-week buy signal on 8x8 Inc. (EGHT) which is bouncing up from a recent selloff.  (SEE DISCLAIMER BELOW).

As noted above, we’re seeing a 12-month buys on the Russian and Mexican stock indexes.  If a hedge is desired, Ireland and Brazil are the top candidates for off-setting short hedges.

Housekeeping and Closing

We 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. 

We have a number of Spring 2013 speaking engagements in New York, London, Toronto, Dallas, San Francisco and Boston – we look forward to seeing our friends in those cities! 

We’ve been so engrossed in our Country and Currency work that we’ve been remiss in announcing the top ranked companies for various sentiments in 2012.  We plan to introduce those companies in the next newsletter.

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:, +1-866-727-7555

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

A Guide to International Investing: Unstable Government? Buy it. Happy Businesses? Short it.

“He has to live in the midst of the incomprehensible, which is detestable. And it has a fascination, too, which goes to work upon him. The fascination of the abomination--you know. Imagine the growing regrets, the longing to escape, the powerless disgust, the surrender, the hate.”
- Joseph Conrad, Heart of Darkness, Part 1

When a government fails – whether due to warfare, failure to provide services, or insolvency and cutbacks - the citizens of the country go through several psychological stages

Unfortunately I’ve witnessed these stages, and gone through them myself.   I used to enjoy off-the-beaten path travel and journeyed to places in transition such as post-Soviet Central Asia in 1992 and Central Africa in 1996 (inspiration for the Heart of Darkness quote above and throughout today’s letter).  The particulars of my experiences are too lengthy and surreal to write about here, but suffice it to say, when the lights go off, the bugs come out.

When a government first falls – when the President flees the country or a brand new group enters power – there is at first hope that business will continue as usual.  This represents the stage of denial.  In the second stage, as laws change or law and order break down entirely, citizens enter a stage of paralysis.  I saw this in the post office in Kisangani, Zaire, where well-dressed postal workers came to work every day despite not having been paid in 2 years and having no work to do.  Paralyzed citizens protect valuable possessions and listen to every rumor for signs of danger.  Their indecision is broken when they realize that inaction will cost them dearly, often leading to the third stage:  disorganized panic and escape. They run away or, if they don’t have the resources to run, they bunker down.  In the fourth stage, they become accustomed to the new order, either learning to live as a refugee or accepting the new authorities and laws (or the arbitrariness of the laws).

In Africa in 1996 I traveled from Uganda to Cameroon overland.  In Zaire (now Congo) the government was absent – warlords and bandits were dividing the country.  And when I was in the Central African Republic, a rebel army was camped outside the capital, regrouping for a second assault.  Adventurous diamond and gold traders remained in Zaire, despite the danger, buying up gold nuggets and uncut diamonds at bargain-basement prices from local miners.  Nothing good came from those African failed states, which remain troubled today, but those hardy entrepreneurs profited handsomely – if they survived.

Bargains and Oligarchs
"I couldn't help asking him [Kurtz] once what he meant by coming here at all. 'To make money, of course. What do you think?' he said scornfully."
- Joseph Conrad, Heart of Darkness

In 1992 after the U.S.S.R. collapsed, prices collapsed with it.  To my surprise and delight, in post-Soviet Central Asia I found I could eat as many delicious local dishes as I wanted and never spend more than $0.10 on food per day.  I saw large hand-woven wool carpets in department stores priced at $50.  And I was offered a smorgasbord of military hardware at tremendous discounts (a MIG fighter jet for $10,000, anyone?  How about RPGs for $100 each?).  When Communism fell, goods became exceptionally cheap.  And this mispricing is how most Russian oligarchs made their fortunes, buying commodities at unadjusted Soviet prices and exporting them to Europe for global market prices.

In both Africa and Central Asia I observed that government instability drove out nervous investors.  The crazy and courageous who stayed behind, if they survived, profited tremendously.  Given these personal experiences, it was incredibly exciting this week when our phenomenal new data scientist, Changjie Liu, discovered the powerful predictive nature of government instability, and other sentiments, in our Country-level sentiment data.  Greater government instability reported in the media signals an excellent opportunity for intrepid investors.

Today’s newsletter looks at the power of national emotions and news headlines in predicting a country’s stock index return.  

Analyzing International Emotion

 For some background – if you follow us regularly you know that at MarketPsych we perform semantic analysis on 2 million articles daily from social and news media.  We have archives of such articles back to 1980 (1998 for the Thomson Reuters MarketPsych Indices).  Our software scans the content of each article in the news and social media flow and quantifies sentiments expressed about specific companies and locations.  Beyond sentiment, we also look for complex concepts such as GovernmentInstability and macroeconomic themes such as MonetaryPolicyLooseVsTight (a measure of easy versus tight monetary policy discussed in news and social media).  Several of the sentiments and themes we track appear predictive of future stock market movement globally.

Extracting emotion about different countries and locations from the business news is very difficult, especially when dealing with a firehose of unstructured information.  For example, we take special measures to exclude travel, entertainment, sports and other business-irrelevant sentiments.  Because all of the language we analyze is English, we are often quantifying an English-language cultural perspective on non-English-speaking countries.

In the Thomson Reuters Indices we produce sentiment for the 120 most economically significant countries.  The sentiments we issue are updated minutely.  You can see the sentiments available below:

Buy Fear, Sell Joy
In today’s newsletter I describe a series of studies we performed on our country sentiment data.  The descriptions are informal, as the research is still underway.  We are preparing a more formal research paper to describe the findings in detail with methodology. 

Note that when I say “our” and “we” in this newsletter, I generally mean Changjie Liu and his semi-magical R scripts.  In our first study we analyzed the 18 countries (for symmetry) with the top Buzz in the news over the past 14 years.  We then tracked the return of the major stock index of that country over the following year.  The list of countries with top Buzz is similar to expectations, as you can see in the list below:

For a given year, we ranked sentiment in each country for the year and went long the top 4 and short the bottom 4 for the ranked sentiment (Joy is inverted below).  Several sentiments stood out, in particular Joy, Fear, Government Instability, and MonetaryPolicyLooseVsTight.  For the sake of brevity I will focus on those in the remainder of this newsletter.

The below chart on the left indicates a 3-fold return from 1999 to June 2012 using a strategy that shorts the stock indexes of the 4 countries with the highest Joy and buys the 4 with the lowest Joy.  We see 10-fold returns if one buys the highest government instability and shorts those with the lowest government instability. 

Lesson to international investors so far?  Buy national unhappiness (low Joy) and GovernmentInstability, short Joy and government stability.

Note that our FinancialSystemInstability variable did not correlate strongly with returns, but our GovernmentAnger, RegimeChange, and ElectionSentiment (inverted) variables had correlations similar to GovernmentInstability.

These returns were interesting, and we wanted to establish their stability, so we also looked at arbitraging the top 2 vs bottom 2 and top 6 vs bottom 6.  See those results below for GovernmentInstability:

There was also a concern that perhaps the same countries were appearing on GovernmentInstability (e.g., Pakistan), and thus biasing the sample.  In fact, there were almost no countries remaining at the extremes of one of the ranking list over the entire 14 year period.  For Joy we see Italy and Spain dominating the high list, but for low, we don’t see as much consistency overall.  Generally speaking, several countries and regions go into and out of the rotation for both the top and bottom groups, which supports sentiment as an independent region and country-selection tool.

We then examined stability of returns for the group of Countries with the largest Buzz over the past year, and we found better returns.  Buzz – a proxy for investor attention – appear to itself be a useful variable for improving country selection.

When we divided the group of countries into Developed vs Developing groups of nations, we continued to see return consistency.  Also we see consistency for a group of European countries only.   In fact, Joy led to much higher returns in Europe only.  The below chart depicts Joy arbitrage in the top 8 highest Buzz European countries, shorting the 2 with highest Joy and buying the 2 with lowest Joy.

We also found that dual-rankings of sentiments led to more stable, and still very good, performance:

We also looked at past stock index return.  There is a powerful mean-reversion effect of past one-year country returns, and arbitraging past return would earn a 5-fold return over our study period.  Fortunately, we found that this effect is independent (for most TRMI) from our sentiment strategies.

There is an interesting philosophical issue with Monetary Policy.  We see that a combination of high Joy and easy Monetary policy leads to greater underperformance.  Perhaps Joy is a proxy for overconfidence that leads to profligate spending and excessively low interest rates.  I hate to be the wet blanket, but national economic Joy may be good for politicians, but ultimately backfires for investors.

Because we found such high returns in high returns prompted some questions, such as, are we losing money to interest rate or currency differentials?  We figure a currency hedge can take care of currency risk, but interest rate risk remains.  We will continue to explore the practicalities of implementing this strategy, and we will soon have a website displaying global investment risk by country based on news flow sentiment.  Stay tuned…

2012 Global Sentiment
In case you’re interested in playing with or implementing such strategies for yourself, please get in touch with Thomson Reuters (or me) to check out a trial of our data.

Below are two depictions of 2012 sentiment generated by our Chief Data Scientist, Aleksander Fafula.  The first map represents Joy extracted from social media.  Darker countries have higher variable values.  I’m not sure what is happening in Morocco, but it must be really good.  White countries have no data available in the TRMI.

Below is GovernmentInstability reflected in news flow for 2012:

Global Emotional Arbitrage
"[Kurtz] declared he would shoot me unless I gave him the ivory and then cleared out of the country, because he could do so, and had a fancy for it, and there was nothing on earth to prevent him killing whom he jolly well pleased."
- Joseph Conrad, Heart of Darkness

During my travels in Zaire, besides learning the basics of how to grade raw diamonds and out-bluff gunmen, I learned that intrepid investors find the best opportunities in places where authority is fragile or non-existent and darkness (low Joy) is endemic.  You may invest in these countries, but don’t forget your bodyguard.

Of course, there are risks to investing in unstable places.  But it is the human tendency to catastrophize – to exaggerate risks beyond their actual danger – that makes these risks so lucrative for enterprising investors.

Is global sentiment predictably driving investment flows around the world?  We believe our data confirms this – English-language news loaded with frightening topics (like government instability) is driving investment flows away from areas where investment would be best allocated. 

Our investigations are ongoing, and we will send a link to our white paper and a global investment risk map when it is ready.  Next newsletter we will name the top and bottom 2 countries for buying and shorting in 2013.  Stay tuned…

Housekeeping and Closing

We 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. 

We have a number of Spring 2013 speaking engagements in New York, London, Toronto, San Francisco and Boston – we look forward to seeing our friends in those cities!

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:, +1-866-727-7555

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