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Market Lucidity Index

This research was conducted to develop the "Market Lucidity Index", an index that offers a relatively quantitative assessment of the market's inclination with respect to interpreting news bearing significant impact on equity markets. This seemingly unachievable goal was accomplished through establishing a rigorous quantitative framework for evaluating market expected reaction relative to actual.

The Market Lucidity Index proposed in this paper carries no forecasting value. It is instead a reflection of the dominant market sentiment with respect to the interpretation of significant economic events. Unlike the P/E ratio or purely technical indicators like Bollinger Bands and RSI, the index detailed in this paper acts as a "litmus test" of the behavioural discrepancy between the market‘s expected reaction and its actual. In conjunction with other indicators, however, it can be used a tool to help identify possible issues with the market (e.g. herding behaviour, severe optimism and pessimism periods) from the behavioural perspective.

By evaluating the research results, we concluded that in 2009 the equity markets exhibited extreme levels of optimism, signalling possible disconnect of the market participants‘ reaction from the underlying economic developments. The index suggests that the fine signals, or "green shoots" of a typical recovery, did not exist to support the rally the way it progressed. Instead, the market went up on sheer optimism and hope, fuelled by unprecedented liquidity measures developed by governments and central banks around the world. A stock market action based on emotions alone possesses tremendous opportunities and danger to the investors, depending on the preceding market action. As the markets rallied on overwhelming optimism in 2009-2010, it is our view that retail investors should maintain minimal exposure to equities until both market‘s behaviour and value come in sync with the long-term norms.


Research paper can be found here:
Measuring the Immeasurable: Market Lucidity Index

Disclosure: No equity positions at the moment