In this past weekend's newsletter (subscribe for free e-delivery) I discussed several macro viewpoints including:
- The current risks in the market given the recent technical deterioration
- The potential for a "market melt up in 2015, " and;
- The warning message being sent by the collapse in energy prices.
I also discussed the importance of understanding "herd mentality," the folly of listening to mainstream analysts predictions and something called "murmuration."
The market is a giant living organism of human behavior and trying to predict what the market will do in two weeks, much less twelve months from now, is pure folly.
However, by looking at the price trends, and using some statistical analysis, we can garner a view of the direction that the “herd” is most likely heading.
There is a fascinating analogy in nature, called murmuration, that very much resembles the “herd mentality” in the markets.
Starlings, which gather in the evenings to roost, will often participate in what is called a murmuration — a huge flock that shape-shifts in the sky as if it were one swirling liquid mass.
This behavior is often sparked by the presence of a predator, like a hawk, and the movement is based on evasive maneuvers. There is safety in numbers, so the individual starlings do not scatter, but rather are able to move as an intelligent cloud, feinting away from a diving raptor, thousands of birds changing direction almost simultaneously.
The question that has had scientists stumped is how a bird, tens or hundreds of birds away from those nearest danger, sense the shift and move in unison?
The secret lies in the same systems that apply to anything on the cusp of a shift, like snow before an avalanche, where the velocity of one bird affects the velocity of the rest. It is called "scale-free correlation" and every shift of the murmuration is called a critical transition.
Giorgio Parisi, a theoretical physicist with the University of Rome, wrote:
"The change in the behavioral state of one animal affects and is affected by that of all other animals in the group, no matter how large the group is. Scale-free correlations provide each animal with an effective perception range much larger than the direct inter-individual interaction range, thus enhancing global response to perturbations."
This is critically important to understand when it comes to investing as the markets, much like a flock of starlings, are an interconnected web of individuals all reacting simultaneously to the same set of inputs. When the "velocity" of a small portion of the “herd” changes, the velocity of the rest of the “herd” is changed as well. The idea of a “scale-free correlation” is a critical dynamic in market movements.
Stockcharts.com has a unique tool call a "relative rotation graph" which they describe as:
"RRG™ charts show you the relative strength and momentum for a group of stocks. Stocks with strong relative strength and momentum appear in the green Leading quadrant. As relative momentum fades, they typically move into the yellow Weakening quadrant. If relative strength then fades, they move into the red Lagging quadrant. Finally, when momentum starts to pick up again, they shift into the blue Improving quadrant."
If you watch the video above of the movement of starlings during murmuration, the animated video below of major market indicies over the last year shows a very similar effect. (Indicies shown: S&P 500, S&P 600, S&P 400, Emerging Markets, International, Nasdaq, DJIA, and NYSE Energy)
(Note: Since energy has been a major headline event I added the NYSE Energy index just for comparative purposes. As you will notice, the energy sector remains highly correlated with the rest of the "flock" until just recently.)
The crucial point is that in the financial markets the herd dictates the general price trend of the markets. Like the flock of starlings, stock market investors become extremely complacent in the financial markets until an exogenous event becomes an identifiable threat and changes the "velocity" of market participants which then ripples through the entire financial organism.
This is why the majority of investors, as shown repeatedly by investor studies such as Dalbar, underperform over time because of investing mistakes associated primarily with "herding mentality." To wit:
"While the inability to participate in the financial markets is certainly a major issue, the biggest reason for underperformance by investors who do participate in the financial markets over time is psychology.
Behavioral biases that lead to poor investment decision making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behaviors:
- Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as "panic selling."
- Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
- Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
- Mental Accounting – Separating performance of investments mentally to justify success and failure.
- Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
- Herding– Following what everyone else is doing. Leads to "buy high/sell low."
- Regret – Not performing a necessary action due to the regret of a previous failure.
- Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
- Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.
These two primary behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of "holdouts" finally "buys in" as the financial markets evolve into a "euphoric state."
As the markets decline, there is a slow realization that "this decline" is something more than a "buy the dip" opportunity. As losses mount, the anxiety of loss begins to mount until individuals seek to "avert further loss" by selling. As shown in the chart below, this behavioral trend runs counter-intuitive to the "buy low/sell high" investment rule.
In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision-making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.
More importantly, despite repeated studies and mainstream commentary that show "buy and hold," and "passive indexing" strategies do indeed work over very long periods of time; the reality is that few will ever survive the downturns in order to reap the benefits. Most investors, like the starlings that are late in making the turn, eventually become "dinner" for the market's predators.