Market Players and Sentiment

The appropriate corresponding timing strategy is to follow informed trader sentiment, act against positive feedback trader sentiment, and ignore liquidity trader sentiment. (Wang, 2000)

Remember from Chapter 5, “An Overview of Markets,” that there are three types of players in any market: the informed, the uninformed, and the liquidity players. The estate that needed to sell stock to raise cash in the discussion of market players in Chapter 5 was an example of a liquidity player. Liquidity players have only a cursory interest in the markets and do not have an important role in determining price trends. They affect the market minimally. On the other hand, informed and uninformed players are the market. Because the interactions between the informed and uninformed players determine prices, we will focus our discussion on those two groups.

The uninformed players are those participants who, being ruled by their emotions and biases, act irrationally. They tend to be optimistic after a market rise and buy, thus creating market peaks, and to be pessimistic during a market decline and sell, thus creating market bottoms. Although the uninformed players are often called the “public,” even professionals can be part of this group. It is not simply the profession or career standing of a market player that classifies an individual as an informed or uninformed player; it is the timing of the player’s optimistic buying and pessimistic selling relative to market highs and lows. Research has found that even professionals such as mutual fund managers, Wall Street strategists, and investment-advisory newsletter writers often behave as uninformed participants. In other words, the majority of market players are uninformed players.

The informed market players tend to act in a way that is contrary to the majority. That is, the informed market participants tend to sell at the top, when the majority is optimistic, and buy at the bottom, when the majority is fearful and selling. Just as uninformed players need not be amateurs, informed players need not be professionals. They can be corporate insiders or day traders sitting in their dens in the Caribbean.

By and large, the uninformed players have considerably more money than the informed players during a market trend. While day to day the informed players stabilize the markets by spotting and acting upon small anomalies in prices and act as contrarian investors investing in undervalued assets, over longer periods, the uninformed tend to overwhelm the price action with their positive feedback, in many instances forcing the informed to ride with the trend of emotion.

Because maximum optimism and pessimism tend to occur at market price extremes, and because this emotional background is principally the provenance of the uninformed player, if the technical analyst can determine how each group is acting, some knowledge of the future direction of prices can be gained. Presumably, the informed professional will act correctly, and the uninformed public will act incorrectly, especially at emotional extremes. If we know that a majority of those participating in the market are extremely optimistic about stock prices continuing on an upward trend, we can conclude that these investors are near fully invested in the market and that stock prices are close to a peak. The sentiment indicators that we discuss in this chapter are designed to measure the extent of investor optimism or pessimism. By using sentiment indicators, the technical analyst is attempting to separate the opinions and actions of the informed players from the uninformed players. The analyst wants to make investment decisions contrary to those that the uninformed group is making and wants to mimic the actions of the informed players.

Box 7.2 Neurochemistry Affect on Human Thinking

Neurotransmitters affect emotion and behavior. At present there have been discovered more than 108 different neurotransmitters that interact, stimulating and inhibiting the activities of each other. “Five of these neurotransmitters act throughout most of the brain: Histamine, serotonin, dopamine, gamma-aminobutyric acid (GABA), and acetylcholine.” (Peterson, 2007 [Inside the Investor’s Brain: The Power of Mind Over Money], p. 48)

“Additionally, local actions of opiods, norepineprhine, stress hormones, and omega-3 fatty acids affect behavior and decision making. And if that weren’t enough, common medications, street drugs, and foods also should be considered for the neural effects on judgment.” (Peterson, p. 50)

“Many pathological mood states (such as depression, mania, anxiety, and obsession), neurological conditions (such as Parkinson’s disease and Alzheimer’s disease), and impulse- control disorders (such as kleptomania, compulsive shopping, and pathological gambling) are known to affect financial decision making: depression is associated with risk aversion, mania with investing overconfidence, anxiety with “analysis paralysis,” and compulsions with overtrading. Interestingly, the financial symptoms of these illnesses can be reduced by medications.” (Peterson, p. 47)

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.