Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Behavioral Finance Lessons From the Stock Market Crash of 2007-2009

Behavioral Finance Lessons From the Stock Market Crash of 2007-2009

Welcome to an Introductory Tutorial to John Bougearel’s Investment Research

Seeking Alpha Readers who wish to see the entire article with charts must email me at jb2@structurallogic.com, thanks

Introduction

What we are going to do today is introduce some of the technical fundamental tools that I employ to create behavioral finance and pattern recognition models that signal trend continuation, trend reversals, and time and price targets in the direction of a trend or countertrend. These models that I build are relatively simple and straightforward. Keeping it Simple Stupid, is Key. And they are the very same models that I used in my financial newsletters to my clients in the second half of 2008 and 2009. This will be a relatively advanced tutorial for active traders and investors, but the principles should be easily grasped by all readers. I will try my best not to assume too much, and I will of course start off with the basics and then get right into the good stuff.  The mission is to give traders and investors an informational edge. Interested in learning more? Read on!

 Specifically, the models that I build and employ in my newsletters are interpretive and dynamic. They are not static models. They are created as market activity unfolds and are revealed to me by Mr. Market. Mr. Market can be likened to an artist whose brushstrokes on the canvas reveal rich content imbued with symbolism and meaning. It is our job as risk managers to be the best damn interpreters of that canvas as possible.  

 This introductory educational article will ultimately focus on my Consumer Confidence Behavioral Finance Model. The Consumer Confidence model has been chosen for its timeliness and relevance for active traders and investors. But before we begin….

 Three Essential Risk Management Skills: Listen, Filter, and be Humble

We have three jobs to do as risk managers. First, it is our job as risk managers to listen, disseminate and parse through what Mr. Market is trying to tell us. Yes, Mr. Market does talk to us. Good listening skills are essential, and I will show you the listening skills I have acquired over the many years of study. My listening skills are one of my interpretive strengths. Not only do I listen to market-moving news, I listen with my eyeballs as well. A good pair of eyeballs is essential for interpreting the markets “symbolic or psychic content” and “carbon footprints” on the chart. You should begin to see these symbolic or psychic “footprints” almost immediately as the tutorial gets underway. Your job is to soak up the strengths that I impart to you like a sponge.

 As your listening skills develop and strengthen, you will begin to simply “just get it.” These are the epiphany “Ah-ha” moments that as risk managers inform us instantly what action is required of us. Mr. Market demands that we as risk managers listen fairly closely to the market so we can cultivate as many of these “Ah-ha” moments as possible. This will require a good deal of your time and energy. Dedication is essential to your success.

 Secondly, it is also our job to learn to filter out what is irrelevant. There is a lot of noise in the markets and in the news. We are constantly bombarded with too much information. In this regard, “Less Is More” is an excellent mantra to internalize when it comes to trading and risk management in particular. It is called filtering and this is another one of my strengths that I need you to takeaway from this tutorial. You must become proficient at filtering. You will find that although I have been a market analyst for more than 15 years, I do not over-analyze the markets.

 

Third, we must be humble. This requires us to recognize that we can not possibly ever know every relevant that is going to affect the markets. Accept that fact! Embrace it and internalize it. Never say something can’t happen, anything is possible. The third principle teaches us that it is okay to be wrong or to not see something. Humility teaches us adopt flexible risk management strategies. It informs and requires us to trade small, not overtrade, and not to stand too close to the market. We don’t want to get burned. And we want to take extra care not to get run over.  I promise you one thing, without stops you will get run over, and probably quite often.

 Mack Daddy Size Respect for Mr. Market

The market is a Mack truck, and when Mack Daddy comes plowing your way, he can inflict a lot of pain upon the imprudent risk manager.

 I speak with expert authority on this matter, as I have been around long enough to have met Mack Daddy on more than one occasion. The lesson learned about ole Mack Daddy, is that markets are quite capable of doing anything. Never forget markets are ubiquitous. They can do anything, anytime, anywhere!

 A case in point can be seen in the 30 year chart above. On March 18 2009 when Bernanke announced the Fed would begin buying treasuries the following week. This came as quite a surprise to many 30 year market participants who were caught offsides that day. They unexpectedly had to cover their shorts, and the 30 year rallied more than 8.5 points off its intraday low that day. The range that day almost engulfed the entire range of the previous two months since Jan 21.  

 

That day was the biggest one day move ever in the history of the 30 year futures. Please, respect what the markets are capable of and manage risk accordingly!  The respect required is the same sort of respect one needs sailing out on a big body of water. Your personal safety is paramount above all else.  As a passing note, please observe the cycle high and low dates occurring around the 18th of the month in the 30 year treasury. There are reasons why this is happening, and we will get into a later chapter that introduces the behavioral finance models specific to the treasury markets.

 Coloring the Days of the Week

On a normal bar chart, all the bars are colored black. Daily price bars feature four main components, the open, high, low and close of a trading session. But beyond those features, there is no way to differentiate one bar from the next. Knowing what day of the week a market tends to set its highs are low for the week can be important. Knowing what economic event took place on a particular day of the week or month and month imparts valuable information for active traders and investors that we can eventually begin to use in formulating risk management strategies.

 

By coloring the days of the week we can add to and enrich the symbolic and psychic content of a daily black bar. It quickly alerts us as chart readers to many other bits of important information. Reading a black bar chart is akin to trying to read a road map in the dark. When I first began to read charts this way, it was like flipping on a light switch on in a dark hallway. On my charts, the ones that I use in my newsletter, Mondays are colored blue, Wednesdays are red, and Friday’s are green. Tuesday and Thursdays are black.


Because non-farm payroll reports are on the first Friday of every month, I know instantly that when I see a green bar in the first week of a new month, that that is a non-farm payroll (NYSE:NFP) day. If all the bars were black, I would not have instantly known that without a lot of unnecessary extra effort. As said above, there is a ton of information to process and filter, too much in fact. It is important that we utilize our time processing information as quickly as possible. By coloring the days of the week as I do, I filter information much more rapidly and the navigation and interpretation of a chart is made so much easier. This way, the symbolic content and carbon footprints, i.e., the brushstrokes of Mr. Market, tend to jump out at you.

 How to Use the Economic Calendar to Your Best Advantage

Beyond the days of the week, there are other light switches that we can use to our advantage. One of those is to consult the weekly and monthly calendars, and be forward looking about it. The financial markets are first and foremost discounting mechanisms. Their function is to allow market participants to hedge and speculate against future risks. That makes it imperative that market participants know what is on both the weekly and monthly economic calendar at all times, including key scheduled speeches.

 In fact, I recommend printing out both a weekly and a monthly calendar to keep at your tradestation. We will get more in depth with how to use the economic calendar in later chapters, but for our educational purposes here, we want to isolate the number one behavioral finance lesson to take away from the Stock Market Crash of 2008-2009. 

 The One Thing

Curly: You know what the secret of life is?
Mitch: No, what?
Curly: [holding up one finger] this.
Mitch: Your finger?
Curly: One thing. Just one thing. You stick to that and everything else don't mean shit.
Mitch: That's great, but what's the one thing?
Curly: That's what you've got to figure out.

 There are many market mantras for risk managers to cling to and internalize. As economic conditions change, the key is to know which mantra is THE most essential to have in your tool kit. You’ve got to figure what that One Thing is for yourself. It can be daunting, even for the most seasoned market veterans. No one gets it totally right all the time, which underscores the third essential skill required of a risk manager: humility and the ability to adapt to adversity, i.e., to be wrong in one’s risk management strategy.

 The Consumer Confidence Behavioral Finance Model

There are many behavioral finance models that drive the stock market. In times of economic crisis, however, we want to find THE ONE MODEL that tells us whether the crisis of confidence amongst investors is worsening or improving.  That one model for us has been the Consumer Confidence model.

 There are two types of confidence for stock market participants to measure, consumer confidence and investor confidence. They are distinctly different animals. At times they converge, and at other times they diverge. Investor confidence tends to lead consumer confidence both up and down, and Mr. Market paints this clearly for us to see on the charts. On September 4 2008, just before the financial crisis entered its climactic stage, investor confidence signaled trouble was afoot.

 Consumer Confidence reports are released on the last Tuesday of every month. Oftentimes, when consumer confidence is swooning, we will see investor confidence swoon with the plunging consumer confidence. This shows up quite clearly on the SP500 chart. The stock market dives down into the consumer confidence reports (the vertical lines on the chart above show the days of the consumer confidence reports since August 2008). Upon close examination, a good pair of eyeballs will note that on most consumer confidence days, when the stock market is declining (remember the stock market is a discounting mechanism) into Consumer Confidence reports, the stock market has a high closing price relative to the day.

 When the stock market declines into these reports, it indicates to us that stock market investors are hedging themselves short when they expect these consumer confidence reports to be particularly bad. When the stock market subsequently closes at its highs for the day, it signals stock market investors are covering their shorts after the release of these consumer confidence reports. High closing consumer confidence reports occurred on August 28 08, Sept 30 08, Oct 28 08, Dec 30 08, and Feb 24 09.

 What concerns us most however is not that the stock market plunged into these reports or that they closed near the highs of these consumer confidence Tuesdays. What concerns us most in a “financial crisis” is when the stock market takes out the low of a consumer confidence report. When this happens, it signals to us that investor confidence is collapsing worse than consumer confidence. The chart above shows three clear instances when investor confidence went into a “crisis” mode. The first instance was on September 4 08 a few days after the August 28 consumer confidence report. The second instance was a few days after the September 28 08 consumer confidence report. The third instance was a few days after the Feb 24 09 consumer confidence report.

 The market has recovered since the March 6 09 NFP low and rebounded well above the Feb 24 2009 consumer confidence low. This is an indication that investor confidence is rebounding nicely and, for the time being, no longer in “crisis” mode. This is consistent with the fact that the financial markets are now a lot less concerned about the woes in the financial sector than they were a few days after Feb 24. What has happened after March 6 to bolster confidence in the financial sector are initiatives from the Fed, US Treasury, lawmakers, and the Obama administration to “do whatever is necessary,’ said Obama, ‘in the weeks ahead to ensure the banks Americans depend on have the money they need to lend, even if the economy gets worse.’” So far, equity investors are buying the administrations efforts and soundbites since the March 6 NFP Friday report.

Through February 2009, consumer confidence has gotten measurably worse since August 2008. But it is worth noting that as investor confidence led the way down into the March 6 2009 low, it is now leading consumer confidence on the way back up. This behavior is entirely consistent with the stock market acting as a discounting mechanism.

 As Obama noted, the economy is apt to get worse before it gets better, but, they said they are going to do whatever it takes to save the failed bank from their recklessness, no matter the cost. If Obama’s efforts are going to bear fruit, then it is essential that any retests of the Feb 24 consumer confidence report be met with success. Market participants should note that the Feb 24 consumer confidence low at 743 is quite near the 2008 year low at 739.

 If ever the SP500 trades and closes below 739-743 in the coming weeks or months, it will be a clear signal that equity investors are entering another “crisis of confidence.” By definition, as March 2009 draws to a close, we are still in a bear market, and if Obama’s efforts pan out to bear little to no fruit, the stock market may well plunge below 739-743 in the coming weeks or months. This will be a clear and strong warning signal for active traders and investors to take appropriate action if it does.

 Conclusion

Always look ahead a week or more on the economic calendar. Tuesday March 31st will be the next consumer confidence report. The stock market appears to have begun another swoon days in front of this upcoming report. Beyond the March 31st consumer confidence report will be another abysmal jobs report on Friday April 3rd, just three days later. There are near term downside risks for the stock market going into these reports. If equity investors crisis of confidence is indeed recovering these downside risks will not take the SP500 below 739-743.

 We would also wish to remind everyone that the stock market tends to rebound after consumer confidence reports. This could repeat again if the stock market swoons into the March 31st consumer confidence report.  Otherwise, we might just get a mid-range close. Low closes on CC Tuesday’s just don’t seem to be a high probability bet to make.

 Disclosure: I am long the SP500 futures from March 6