What To Rely On When Markets Have A Mind Of Their Own

by: Invest With An Edge

By Jerry Wagner

How many times have you started typing something on your phone and the result is simply gobbledygook? Or you click an icon for an app and your camera opens up. Then, of course, when you need your camera, some other app opens. The device just seems to have a mind of its own.

It happens so often in life. Grab the cart in a supermarket with the wobbly wheel, and no matter which direction you push it, the cart goes its own way.

Psychologists say the same things happen in our minds. We really have two centers of thought. The first is our deliberate mind. It's what we think of when we think of the workings of the mind. The deliberate mind carefully considers the pros and cons of something over time before acting.

The other part of our brain is our instinctual mind. It assesses matters in an instant and acts.

Each of these comes into play at different times. However, it seems like it is the instinctual mind that leaves people shaking their heads.

The 2-year-old in the supermarket often isn't behaving as mother taught her. Instead, she is said to have a mind of her own. Even when the deliberate side of the brain is at work, like when a teenager doesn't go to college when his parent recommends it for all of the right reasons, the teen is said to have a mind of his own.

Since this phrase seems to infect inanimate things, our minds, and people in general, it should come as no surprise that financial markets seem to also have minds of their own. While we may shake our heads at some of the earlier examples, not comprehending the rationale behind them, the market's lack of predictability at times actually does make sense. After all, the behavior of the market merely reflects the collective behavior of all of the market participants.

And these participants have very different needs and goals in terms of their investing. You mix all types of people with different occupations. You add in professionals and amateurs. Young people, old people, income and growth investors, hedge funds, 401(k), and IRA holders are all blended together and represented by the current value of each stock or bond and in the twists and turns in direction of each individual security.

This is one of the many reasons why trend following is so popular as a method for managing money. Price is said to reflect all of the information in the market. It can't be artificially inflated, like financial statements, or hidden for a time by insider or high-frequency trading. Each participant's actions have consequences, and they add up to the current value we assign to financial assets.

That does not mean that price is always right. Its change of direction does highlight the trend, and that is an investor's friend. And staying with it will usually be the right path to follow. But price can also be very wrong - just as the collective can be wrong. That gives rise to under- and overvaluing, from which an opportunistic investor can profit. Dynamic, risk-managed investing seeks to take advantage of both of these phenomena.

Still, even with these tools, an investor cannot always be on the right side of every trade. There are times when the market seems to have a mind of its own. When the Federal Reserve started raising interest rates in December 2015, many investors abandoned the stock market; rising interest rates are supposed to be bad for stocks. Stocks have trended higher despite the conventional wisdom.

This year tariffs were proposed and actually imposed. Tariffs are bad for economies, and bad economies are bad for stocks, we are told. Yet, we ended last week with the S&P 500 9% higher than it was when the year began.

Yes, the market often seems to have a mind of its own. Financial behaviorists tell us that in the face of uncertainty the best approach is not to try to follow the advice of experts but rather to look to quantifiable measures of probability to separate ourselves from our own emotions.

They replace the emotions with discipline. Taking the action with the highest probability won't always be right, but quantifiable methodologies are designed to come out ahead most of the time in the long run - even during times like these when the market seems to have a mind of its own.

Market update

As further proof that markets have a mind of their own, check out this bullish sentiment graph from the American Association of Individual Investors (AAII). Last week individual investment sentiment rose dramatically from a percentage in the low 30s to almost 46% - the highest level since last January!

And just as stocks that month swooned, all of the major market indexes finished down last week as well. The Dow Jones Industrial Average lost 0.04%, the S&P 500 Stock Index fell 0.97%, the NASDAQ Composite fell 3.21%, and the Russell 2000 small-capitalization index lost 3.80%. Hopefully, stocks won't tumble into a correction (a loss of more than 10%) like they did when this happened at the start of the year.

Stocks that had been leading the market - such as the FANG stocks [Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), and Google (Alphabet) (NASDAQ:GOOG) (NASDAQ:GOOGL)] - are down more than 10% since their top in June. The NASDAQ 100, this year's top-performing index, has been leading the indexes lower for the last few weeks.

Earlier in the summer, stocks had been responding well to earnings reports. Generally, on their earnings reporting day, stocks had registered gains. But last month that changed. Despite most companies beating their earnings estimates, stocks generally fell on reporting days.

Obviously, this has provided a reason for the recent weakness in stocks and reinforced the "markets have a mind of their own" theme of this article. Studies show that when the September earnings-day reactions average a negative 1% or more (as was the case this September), a similar fate likely awaits the market in the face of the subsequent third-quarter earnings data (to begin November 10).

Still, not everything is negative in this week's outlook. While economic data has been disappointing, we may be near a cyclical bottom in such reports. Normally, economic reports exceed expectation in the last quarter of the year.

An example of this can be seen in the ISM service and manufacturing data reported on in the last two weeks. Last week, the nonmanufacturing report registered its second-highest reading since the series started in 1997, and the combination of the two reports hit its highest level in history. Of course, the blockbuster employment report did not disappoint either, as the unemployment rate fell to the lowest rate since 1969.

Similarly, indicators that normally foreshadow a recession continue to suggest otherwise. For example, my top recession indicator is the inverted yield curve. Measured as the difference between 10-year government bond rates and the two-year variety, the yield curve is said to be inverted when the difference between the two rates is negative (longer-term rates are less than shorter-term rates).

The inversion usually occurs over a year in advance of a recession (sometimes it's even three years early). And as the following chart demonstrates, the best signals come when the difference returns to above-zero levels after the inversion. Last week the yield curve actually steepened and has yet to fall below the zero mark, so all's good on the recession front.

Further on the plus side, stocks are oversold. Historically, stocks have been the place to be in October and throughout the fourth quarter in midterm election years.

Once a trend starts, stocks normally continue to move in the direction of the trend. Yet when the NASDAQ Composite has fallen during the first five days of October (again, like this year), in every year but one since 1972, stocks have risen during the rest of the month.

Yes, markets do have a mind of their own.

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