Limits of Perception in Market Analysis

Dec.13.06 | About: SPDR S&P (SPY)

One of the signs that a field of study has become a science is the recognition of the need for controlled observation with tools that transcend the limits of the human senses. From the electron microscope to the Hubble telescope, advances in science have followed the acceptance that the unaided human eye cannot perceive all of nature's patterns.

Behavioral finance researchers teach us that unaided human senses are particularly ill-equipped to accurately assess the market's patterns. Our tendencies to overweight recent events and highly salient events; our overreliance on simple heuristics; our emotional weightings of losses vs. gains: these create perceptual biases that skew our responses to risk and reward under conditions of uncertainty.

Still, surprisingly, we find traders evaluating markets based upon nothing more than the unaided eye. Inevitably we look at a chart, notice a slope, and declare a "trend" in place. Can such visually-based analysis succeed?

I decided to try a little experiment. I went back to 2004 (N = 734 trading days) in the S&P 500 Index (NYSEARCA:SPY) and identified all occasions in which the market was up on a one-day basis, a four-day basis, and a nine-day basis (N = 234). We might call that an "uptrending" market. Four days later, SPY was down by an average -.07% (115 up, 119 down). That is weaker than the average four-day gain for the remainder of the sample of .22% (299 up, 201 down). In other words, the market that--to the unaided observer--has been consistantly up over the last two weeks has had no bullish edge whatsoever. Indeed, it has tended to underperform its recent norms. This fits with my recent research showing underperformance when we trade above a moving-average benchmark.

But let's take the experiment a step further. Suppose we isolate those occasions in which the market is up more on a nine-day basis than on a four-day basis and up more on a four-day basis than on a one-day basis. This would represent, to the unaided eye, a nice steady uptrend. We have 115 such occurrences in our sample. Four days later, SPY is down by an average -.11% (53 up, 62 down). When the market has been down on a one, four, and nine-day basis, but not in a visual uptrend, the next four days in SPY have averaged a loss of -.02% (62 up, 57 down). In other words, we've seen the worst short-term market outcomes when markets have looked their best. The more consistent the visual uptrend, the worse the near-term returns.

In my next post, I will investigate our perception of markets moving downward.

The perceptual distortion in the market is that the unaided human eye tends to extrapolate straight lines into the future. Like a ball tossed into the air, we expect markets to continue moving in their most recent direction. Statistical analysis is a tool for transcending the unaided eye. It, among other things, is what separates astrologers from astronomers, alchemists from chemists. Market psychology begins with the recognition of the limits--and limitations--of human perception.