Trading an Emotion-Driven Market

Includes: DDAIF, QQQ, SPY
by: Sean Hannon

Most people view themselves as rational decision makers, but few are consistent. Although most actions we take are based on careful decision making, it is difficult to filter external noise. Instead of confronting each event individually, perceptions are often swayed by outside factors. A house may be designed to provide shelter and comfort, but more people allow the size of the house next door to sway their opinion of their own home. By ignoring what their home should be and deciding to compete with the neighbors, emotions trigger irrational decisions.

The same problem applies to the stock market. Comparing daily and weekly price gains, most people ignore the raw data and allow recent events to influence their opinions. When the Dow Jones Industrial Average (Dow) crashed nearly 1,000 points on May 6, the television shows focused more on the bounce from the intra-day low than the fact that the Dow still declined 346 points on the day. I cannot remember the last time a 300-point drop was seen as good news, but anchoring on the crash influenced perceptions.

The reverse played out this past week. With the S&P 500 moving 2.2% higher, it was a solid week. However, the trend of prices produced a different feeling. Markets initially rallied sharply on the European Union's (EU) rescue package, but then faded over the remainder of the week. Finishing with consecutive daily declines, never has a 2.2% weekly gain felt so bad.

Understanding anchoring and emotions will be essential over coming weeks. A market that once rallied on every piece of information has taken a skeptical turn. Recently, the majority of market movements have been driven by investor sentiment and I expect that process to continue. Economic numbers are improving and companies are reporting robust profits, but until concerns over extraneous shocks such as Greece wane, it will be difficult for markets to move much higher. Instead, we should expect the trench warfare to continue with prices swinging wildly, but making little overall progress.