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Yoni Jacobs, CMT, is Executive Director and Chief Investment Strategist for Chart Prophet LLC. As a money manager and financial advisor, he develops and implements targeted investment strategies for individuals, family offices, and institutions. As a fund manager, he builds highly-diversified... More
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  • How Social Mood Affects Stocks, Sports, Elections, And War 0 comments
    Jan 23, 2012 10:21 AM | about stocks: AAPL, EEM, LULU, GMCR, OPEN, ZNGA, AMZN, EWZ, GOOG, MSFT, SDS, FXI, GRPN, NFLX, T, EDZ, FXP, LNKD, NKE, TZA
    "Events do not shape the forces of the market; it is the forces behind the market that shape events."

    -Prechter, The Elliott Wave Theorist, 1979

    The negative social mood that accompanies recessions may help us predict accounting fraud, anti-trust activity, social upheaval, major wars, the popularity of sports, and even the outcome of presidential elections.

    Investors, economists, and the majority of the world believe that specific events trigger a rise or fall in stocks. Most believe that the stock market reacts to events that take place. The Socionomic perspective, however, is based on the principle that specific events such as revolution, war, recession, and success are the result of a social mood that has already been established for some time. In other words, things only happen if the people's mood matches the mood of the events. In essence, the stock market does not react to events; it enables them.

    Stock prices obviously don't control the world. Other outside forces and factors are in play throughout the course of history - from economic conditions to religious movements to international relations, etc. But since the stock market is a very strong measurement of the health or fragility of economies and social mood (since it is a widely-watched representation of businesses and investor optimism or pessimism), we can most accurately gauge and predict future conditions by monitoring trends in stock prices and social mood. In other words, if we can evaluate changes in how people feel, we can predict how they will soon act.

    Since the bursting of the technology bubble at the turn of the century, the world has been on a rollercoaster ride. Technology stocks, housing, and oil have soared and then collapsed on investors; economies have transitioned back and forth between sustainable growth and disastrous risks; and the future is more uncertain than ever, as global markets are moving at incredible speeds and are more interconnected than ever before. There is no doubt, then, that the massive volatility in stock markets over the past 10+ years has transferred over and affected the mindset of people all over the world. And it is the mindset and expectations of the people that will determine our future.

    We are currently at a major turning point in history. We stand at a crossroads between an economic "recovery" and potential for a double-dip recession. It seems as if the risks are constantly growing - huge government debt, threat of war, slowing growth, unsustainable price increases in many assets, and tremendous macro issues threatening Europe and the Middle East. The world is either largely ignoring these major risks, or too fearful of the consequences. If we are ignoring the potential devastating impact, we set ourselves up for major upheaval and economic disaster; but if we over-emphasize the risks, we could be approaching great economic times as our fears subside.

    The key here is figuring out what the world is expecting. If investors, institutions, and businesses are too optimistic, they will likely meet a disturbing reality in the near future. On the other hand, if they are too pessimistic, they will likely be positively surprised. It is my view currently that we have not yet recovered from the devastating shock of the Great Recession of 2007-2009; the stock market is still below the 2007 peak, investors are wary but somehow still overly optimistic about emerging markets and technology stocks, and it appears we have just "kicked the can down the road" and failed to deal with the massive issues that plague our economies. In short, the stock market has seen such a huge bounce since the 2009 lows while the risks have escalated tremendously - these are horrible ingredients for a sustainable economic recovery.

    Our goal here, then, is to present you with the potential outcomes and events that may transpire over the next few years - and how they will affect companies, economies, countries, and your personal wealth.

    What Social Mood Predicts, and Proof That It Has Already Begun

    Other than a big downturn in stocks, a negative social mood is also accompanied by political changes, social discontent, monopoly-busting, the exposure of fraud, popularity shifts in sports, and even war.

    Presidential Election

    Strong and persistent trends in the stock market determine whether an incumbent president will be re-elected in a landslide or defeated in one. In all cases where an incumbent remained in office in a landslide, the stock market's trend was up. In all cases where an incumbent was rejected by a landslide, the stock market's trend was down.

    - Prechter, The Elliott Wave Theorist, November 1999

    With the Republican Party deep into its process of determining the next presidential candidate, many are wondering who will challenge President Obama in the election and whether that candidate will be able to take over and win. Politicians, scholars, investors, and the media are all wondering how each candidate's policies and worldview will affect the outcome of the race and the potential time in office. However, few people are looking at the stock market in determining the likely winner of the upcoming presidential election.

    One recurring theme seems to be crucial in elections: the trend of the stock market. If stocks consistently rise, voters tend to stick with the President who they see as responsible for the good times; on the other hand, if stocks consistently fall, voters are fed up with the leadership and tend to look for a change by ousting the current President and voting for someone new.

    The socionomic conclusion is this: When social mood waxes positive, as reflected by persistently rising stock prices, voters desire to retain the leader who symbolizes their upbeat feelings and who they presume helped cause the conditions attending them. When the social mood becomes more negative, as reflected by persistently falling stock prices, voters decide to throw out the incumbent who symbolizes their downbeat feelings and who they presume helped cause the conditions attending them.

    - Prechter, The Elliott Wave Theorist, November 1999

    Knowing that stock prices have a measurable effect on election outcomes, we now have a better understanding and higher probability of predicting the next President. The stock market was remarkable from the 2009 bottom until early 2011, but has since been highly volatile and on the verge of a sharp drop. Huge government debt, the Flash Crash, the collapse of MF Global, and what appears to be government manipulation of the markets are all big threats to future stock prices. If these are signs of a growing negative social mood, perhaps President Obama may have a tough time getting reelected. However, in order for a decisive win in the upcoming election to take place, the stock market must make a decisive move from now until then. Obama has the huge 2009-2011 run-up in stocks as support for his campaign, but if the market can't sustain the gains over the next few months, we may see a new president next year.

    Actionable strategy: We are currently right at a major pivot point of 1270-1340 on the S&P 500 and 12,200-12,800 on the Dow Jones Industrial Average. The massive drop in stocks from May to September 2011 may have been the confirmation of a shift to a negative social mood. The test now stands at this turning point we find ourselves in: if stocks fail at these levels and begin the next leg down, Obama could have a hard time getting re-elected; if stocks continue up, however, the negative social mood may not be fully intact and Obama has a strong chance of re-election.

    For those looking to use this as an investment or trading strategy, a good move would be to watch this level closely and take one of two actions. For those who are bearish or would like to speculate on falling stock prices, shorting the broader markets or specific over-valued stocks may be a great way to take advantage of this low-risk pivot point. Broad markets can be shorted through short positions on US markets (SPY or IWM), emerging markets (EEM) including China (FXI) and Brazil (EWZ), or through short inverse ETFs that rise when the underlying asset falls - such as short S&P 500 (SDS), Russell 2000 (TZA), China (FXP), or emerging markets (EDZ). Specific stocks worth shorting should be based on an already-established downtrend, more favorably if they are highly over-valued in terms of P/E ratios or unsustainable growth forecasts [like Netflix (NFLX), Green Mountain (GMCR), or Opentable (OPEN) were in 2011]. The short strategy is a great low-risk trade at these levels, with the stop-loss and getting out of the trade if the stock market rises and breaks above the top of our overhead resistance area (approximately 1340 on the S&P 500). For those who want to avoid shorting stocks and prefer to go long at a low-risk point, we recommend waiting to see if the stock market can break above our overhead resistance area; if stocks break above that level, investors can enter right above the resistance area (which now becomes support) and sell out of the stocks if the newly-established floor doesn't hold.

    War

    Global conflict is a product of a downturn in social mood.

    - Prechter, The Elliott Wave Theorist, June 2001

    As US troops pull out of Iraq, our involvement in wars is still not over. The US has a long history of getting involved in global conflicts, helping the needy, and meddling in other countries' business. We can't blame the US government, since that seems to be what the world-leading country tends to do throughout history. The US is, in effect, the world regulatory agent and also a protector against terrorism and human rights violations. Whether or not the US has fulfilled its role correctly is up for debate, but the view that the US is likely to be involved in the next global conflict is almost inevitable.
    The Mideast's record as an early register of negative social mood suggests that a major bear market and thus the trend toward global hostility has only just begun.

    - Prechter, The Elliott Wave Theorist, June 2001

    The world seems to be in the midst of a sweeping negative social mood, as the violent tensions initiated on September 11, 2001 have led to US occupation of Iraq and Afghanistan, and are further exacerbated by the tremendous upheaval in the Middle East. Violence is rampant in the region now, with social discontent and revolutions disrupting the order that seems to always be on the verge of collapsing. Now, aside from the ongoing problems in Iraq, Afghanistan, and Pakistan, the threat of war and severe global violence has skyrocketed with Iran's growing militarization and conflict. Iran has been developing nuclear weapons, displaying its navy and army as a scare tactic, and even threatening to destroy other countries. The US knows Iran may be the center of future conflict, and is attempting to curb growing tensions. But it may be too difficult or too late to do so, as Iran seems to be preparing for violence. Add to that the death of North Korea's leader Kim Jong-il, a long-time nuclear threat, and tensions could easily rise.
    A persistently rising stock market, reflecting feelings of increasing goodwill and social harmony, should consistently produce peace, and a persistently falling stock market, reflecting feelings of increasing ill will and social conflict, should consistently produce war.

    - Prechter, The Elliott Wave Theorist, November 1999

    As social mood becomes more negative, people become more fearful, distrusting and angry. They are impelled to prepare to defend themselves or attack an enemy.

    - Prechter, The Elliott Wave Theorist, November 1999

    Wars tend to break out in times of negative social mood, as anger, hostility, and hatred are more likely to surface and escalate. Considering the economic troubles we have seen over the past few years as well as the potential for entering a renewed global recession, it is not unlikely that the increasing negative social mood will lead to continued wars or renewed global conflict.

    If the claim that a negative social mood consistently produces wars sounds like mere theory, take a look at the following chart dating back to the 1700s that shows how history's biggest wars have uncannily coincided with bear markets. If this multi-century-old pattern continues, we may be approaching a similar fate.

    Source: Robert Prechter

    Actionable strategy: If social mood has been in a negative cycle since the peak of the dot-com bubble in 2000, our extraordinary bounce in stocks from 2009 until May 2011 may have been just a temporary pause before the next leg down. If stocks begin the next leg down from these levels, a negative social mood would be confirmed and a war would potentially be on the horizon.

    Sports

    Basketball is the ultimate bull market game.

    - Prechter, The Elliott Wave Theorist, December 1996

    As Prechter, ElliottWave International, and the Socionomics Institute point out, social mood and wave analysis can be applied to the popularity or rejection of various sports. Using social mood, they have predicted decreasing popularity for baseball and baseball cards, decreasing player salaries, and emergence of more violent contact sports that embody the pervading negative mood. So far, they seem to be remarkably accurate - baseball card values have dropped precipitously, Alex Rodriguez marked the record salary ever by a baseball player (a record that he has held for over 10 years), and UFC's ultimate fighting mixed-martial-arts has seen an exponential rise to fame as it is nears peak popularity and is now broadcasted on Fox TV. The "good guy" sports like baseball and basketball are not as popular as they were in their prime; the "tough guy" sports, like football and ultimate-fighting, are growing as negative mood brings with it a more aggressive mindset.

    One of the most recent signs that negative social mood is upon us - the cancellation of 20 percent of the 2011-2012 NBA season. If Prechter is correct that "basketball is the ultimate bull market game", the significant conflict and lockout that almost led to the cancellation of the NBA season may be a sign that we are no longer in a bull market.

    Actionable strategy: Being able to predict the growing or declining popularity of certain sports would be very beneficial to companies like Nike (NKE), Lululemon (LULU), and Under Armour (AU), as they could improve sales and efficiency by targeting the right market. Though basketball-related merchandise is still expected to sell, for example, these companies could better prepare themselves by increasing their efforts in the more "bear-market-friendly" sports. For investors, this could mean that a profitable opportunity may be approaching for those who short basketball-related companies.

    Anti-Trust Activity

    Major antitrust suits coincide remarkably consistently with the passing of major stock market tops.

    -Prechter, The Elliott Wave Theorist, May 2000

    Negative social mood allows bad news to surface. When times are good and the stock market is doing well, people do not tend to complain as much. But when stock prices are falling and the negative social mood takes firm hold, the domino effect amplifies pessimistic behavior. In other words, though people have reason to complain and governments have reason to take strong action during good times, they tend to do so only after bad times are well underway.

    One consistent example of how social mood affects government intervention and investor discontent is the bi-polar occurrence of anti-trust activity and bailouts. During good times, monopoly-like companies are allowed their power even if competition is at a major disadvantage. On the other hand, during bad times, anti-trust activity picks up and the government and regulators scrutinize dominant companies and can even over-punish them. Case in point - the attack on Microsoft (MSFT) as a monopoly at the peak of the technology bubble in 2000 was both a sign that negative social mood was picking up and that strict regulation and "fair play" were being enforced. During good times, Microsoft and other dominant companies are left alone; but when bad times emerge, the negative social mood makes people and governments much more vigilant in correcting what was overdone during the bull market.

    At tops, the government initiates force to stifle free competition and success; at bottoms, it removes force that has stifled free competition and success.

    -Prechter, The Elliott Wave Theorist, May 2000

    After the financial carnage of 2007-2008 on banks and businesses, the government bailed out failing institutions in order to "save" the system. In this case, the damage was so great that the approaching "bottom" in stocks enabled the government to help the institutions rather than punish them. The proper action is still debatable - whether failing institutions should be allowed to simply fail or whether they require saving; but one thing is clear: when negative social mood takes its toll and the market nears a bottom, regulation and trust-busting is greatly reduced and allows for bailouts.

    We are currently at the opposite side of this phenomenon: the passing of market tops coincide with anti-monopoly activity and punishment of the strongest companies. Just as Microsoft was the target of regulation and trust-busting as social mood turned negative in 2000, so too will some of the largest companies today be targets of regulation and scrutiny as the negative social mood takes firm hold. If that is the case, we can expect companies like Apple (AAPL), Google (GOOG), Amazon (AMZN), and Facebook to be the focus of much outrage over the next months or years as the excesses of the bull market are cleaned up.

    Apple of today is strikingly similar to Microsoft of 2000: it dominates the sector it does business in, it is a consumer favorite, and it has the largest market cap in the US. It is not far-fetched to think that Apple may face similar hurdles in the future as negative social mood brings with it a critical and disapproving inquiry into the company. Additionally, it is plausible that regulators and others will take a harsher view at Google for its questionable data-mining or near-monopoly on search, at Amazon for its near-monopoly on books and e-commerce, and at Facebook for its questionable privacy, data-mining on users, and doubtful valuations. Once governments, regulators, and investors start to truly take a closer look, they may find many things to nit-pick at and potentially challenge.

    There is proof that anti-trust activity and scrutiny is already taking place. Firstly, the AT&T (T) takeover of T-Mobile for $39 billion was met with strong opposition by the Obama administration and ultimately failed as AT&T withdrew the bid after much resistance (see: http://dealbook.nytimes.com/2011/12/19/att-withdraws-39-bid-for-t-mobile/). Such a large merger/takeover failing to take place is a sign that anti-trust activity is growing and that this may be just the beginning of similar action in the future. Secondly, Senator Jay Rockefeller announced that he will conduct a hearing to determine Facebook's tracking of users after they log out of their accounts. Facebook's tracking of user history and information has been known for a few years now, but perhaps it takes the negative social mood to actually bring some action and regulation. Finally, Google is now under scrutiny by the FTC as Google+ is accused of violating consumer privacy and making Google+ user information available in search results. Whether or not these investigations materialize into bigger problems is one thing, but these examples prove that the environment of greater scrutiny and a "watchful eye" is expanding and that a time of trouble for the powerful companies may be at hand. The onset of the negative social mood bodes poorly for some of the most dominant companies.

    Ironically, the regulation and scrutiny that has been appearing may be too little too late:

    Reform and regulation are one step to regaining the public's confidence. But that often happens well after much of the damage is done to investors' trust. "The government takes steps after the horses have left the barn."

    -Prechter and Kendall, The Elliott Wave Theorist, June 2002

    Actionable strategy: If the market continues another leg down as it did from its May 2011 peak, the growing environment of regulation, scrutiny, and anti-trust activity may be ineffective, as it comes well after investors get clobbered. Moreover, if falling stock prices and increasing scrutiny are at hand, investors could profit by shorting broad markets (as discussed above), shorting the broad technology sector (QQQ or XLK) since many of the largest companies to be scrutinized may be technology companies, or shorting individual companies that could be anti-trust targets [such as Apple , Amazon , or Google ] - though must be done carefully.

    Occupy Wall Street

    The social mood shift that occurs at the transition from bull market to bear includes a change in general attitudes toward the financial success of others. Society moves from a feeling of support toward one of resentment.

    -Prechter, The Elliott Wave Theorist, May 2000

    The onset of negative social mood brings with it strong feelings of resentment and discontent. It is no surprise then, that movements around the globe have sprung up to decry the inequality between incomes and ill-treatment of certain social groups. If negative social mood makes people upset about the difficulty of getting jobs or living a financially stable life while the rich prosper at their expense, the emergence of protesting groups such as Occupy Wall Street should not be so much of a shock. Occupy Wall Street may have faced much resistance due to the protestors' poorly organized or inadequately-focused campaign, but the concerns and outrage of the movement are fair in my opinion - the protestors' are complaining about the income inequality in the US (1% vs the 99%). While income inequality has been a problem throughout history, the negative social mood has enabled the protests to gather steam and gain enough momentum to attract mass-media attention. The Occupy Wall Street protests may be just the beginning of a series of movements aimed at creating a balance between the wealth in this country; and if the negative social mood continues, more violent campaigns are definitely not out of the question.

    Actionable strategy: If Occupy Wall Street is a sign of growing negative social mood, we can expect stronger, perhaps more violent movements to spring up in the future. If that is the case, the downtrend in stocks is far from over. As mood continues to deteriorate, the stock market should register the decline in mood by falling as well. Shorting stocks in this case would therefore be a profitable strategy.

    Fraud

    As the bear market unfolds, many more "scandalous" cases will be revealed.

    -Kendall, The Elliott Wave Theorist, September 1998

    Just like anti-trust activity almost disappears during good times and picks up during bad times, so too does the exposing of fraud remain almost invisible during times of positive social mood and rampant as the negative social mood picks up. The reason for this is as we have explained above - that during boom times, investors and regulators tend to look the other way or simply fail to notice the fraud going on around them.

    Bull markets tend to hide "creative accounting":

    The mass psychology of the stock mania, which was unskeptical to an extreme, invited and even rewarded companies for "creative accounting." It was the psychological environment of the bull market that led companies to dare to mislead investors in the first place.

    -Prechter, The Elliott Wave Theorist, June 2002

    However, when the negative social mood picks up, investors and regulators start to notice and even search for the fraud and manipulation that they missed during the bull market:

    Corporate misbehavior persisted for a decade, but there was no scandal until well after the trend changed. While the trend was up, people ignored the phony accounting; when the trend turned down, they began to investigate it.

    -Prechter, The Elliott Wave Theorist, June 2002

    The "questionable bull market accounting standards (Prechter)" that sometimes run rampant during the good times come to an end when the negative social mood causes regulators and invewspaper and media headlines and may even go bankrupt as their scandals flare up. Other companies, who may not even be involved in scandals, may be hurt as well, as the deeply negative mood takes its toll on any company that investors or regulators may consider to be linked to the fraudulent companies.

    A number of fraudulent companies have already been exposed (a handful in China), and more may soon be uncovered. What companies will potentially suffer from closer scrutiny? Other than emerging market companies in which US investors have blindly poured their money into without truly verifying the accuracy of their financials [think China or Brazil ], companies like Netflix , Groupon (GRPN), LinkedIn (LNKD), Zynga (ZNGA), and other hot IPOs and unproven companies may also be exposed as frauds.

    As I mentioned a number of times regarding Netflix , the company may have been involved in questionable accounting practices and potential fraud which, if uncovered, could lead it to severe legal action and possible bankruptcy:

    • By overstating its earnings and hiding much of its liabilities off the balance sheet, Netflix may have been involved in accounting manipulation and fraud, which could bankrupt the company if surfaced.
    • Management has been increasingly shady and potentially fraudulent, with a mysterious resignation by the CFO at the end of last year as well as massive insider selling of shares by CEO Reed Hastings and other officers. The CEO has essentially been selling millions of dollars-worth of shares to the latecoming small investors who trusted in Netflix.

    Source: Yoni Jacobs, Will Netflix Disappear?

    Additionally, the extremely popular technology startups of the past few years have caused such euphoria and mania among investors that they too may be the subjects of much scrutiny in the future, since their financials have yet to be proven. These companies have attracted billions of dollars of investment and such lofty valuations, yet they still do not earn even a fraction of their valuations in revenues. Investors are expecting massive profits over the next few years, but their failure to truly scrutinize these flimsy companies may come to bite them in the end as the unproven financials never materialize. Even worse, the tremendous euphoria on the part of investors may have caused them to turn a blind eye to some misleading or fraudulent accounting. If negative social mood is taking hold, expect investors and regulators to begin to take a tougher stance and even investigate (See: Is IPO Mania Warning of a Tech Bubble 2.0?).

    Actionable strategy: If negative social mood causes investors and regulators to investigate further into financials and search into potentially fraudulent or unproven companies, investors and speculators may profit from short positions in the tech-bubble-like IPO stocks [Groupon , LinkedIn , Zynga ], potentially-fraudulent Chinese companies, Netflix , or some of the financials (think banks or life-insurance companies). The safest move would be to simply avoid companies with shaky financials or unproven track records. Perhaps no company embodies this group more than Facebook.

    Conclusion

    As the negative social mood picks up (and is visible in the falling stock prices), we can use Socionomics and the study of how social mood affects stock prices to assess our position within the boom-bust cycle and to even predict the outcome of elections, the onset of wars, the uncovering of fraud, the popularity of sports, the emergence of anti-trust activity, and the growth of social discontent. Being able to determine the social mood makes us much more accurate in evaluating our economic position and predicting the future direction of stock prices. If the signs we are seeing are reliable, it appears we are in the midst of a negative social mood, which bodes poorly for stock markets, warns of upcoming wars, and indicates a period of increased regulatory scrutiny. Yet while negative social mood brings with it some serious consequences and calamitous circumstances, it also helps clean up the unsustainable excesses that coincided with the bull market. Moreover, being able to spot the onset of a negative social mood could put us in a much better position to avoid big investment losses and even profit as certain stocks or markets fall.

    Disclosure: I am short NFLX.

    Additional disclosure: Short NFLX through put options

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