Leading Indicators Of Behavioral Finance

By Derek Polcyn AAA

Modern finance relies on two key assumptions: a rational homo sapien and a "fair price" being determined by financial markets. Behavioral finance does not serve as a contradiction to these tenets, but complements them by emphasizing the importance of human psychology and groupthink in financial markets. Behavioral finance points to the existence of market bubbles and manias as examples of cases where human behavior may be the missing link that explains such market anomalies. In this article we'll consider two leading behavioral indicators. (To read more on behavioral finance, see Taking A Chance On Behavioral Finance, Understanding Investor Behavior and Mad Money ... Mad Market?)

Search for Reliable Indicators
Many people assume that it should be fairly easy to outperform the market simply by replicating the strategies used by successful professionals and/or taking the opposite position held by the "losers". Unfortunately, successful investors are very good at hiding their true strategies, which could quickly become worthless if replicated. On the other hand, the behavior of the "losers" or the "crowd" can be easily observed by taking note of certain leading behavioral indicators (the odd lot theory, for example). These indicators show that the "crowd" can be reliably wrong at important market junctures as people fall prey to the collective emotions of fear (at market bottoms) and greed (at market tops).

Let us consider two leading indicators of investor behavior and stock prices:

1. The put-call ratio
2. The number of stocks above their 50-day moving averages (A50 for short)

In contrast to many other attempts to apply behavioral finance theories, these two leading indicators have the virtue of being quantifiable; in other words, they indicate the potential tipping points in human emotions. Keep in mind, however, that the construction of quantifiable indicators is one of the biggest challenges for behavioral finance and all indicators should always be interpreted in a broader context.

Put-Call Ratio
The fact that most option market positions are held over a short period (between one and three months) indicates that, at the very least, some option buyers are investors looking for a quick return on their money or are often just speculating. The buyers of puts could be making a bet that the market will decline while the purchasers of calls are hoping for an upward move. Thus, a high put-call ratio indicates a high degree of pessimism - it suggests that more people are betting that the market will go down than that it will go up. A low ratio, on the other hand, implies a lot of optimism. (For further reading, see Forecasting Market Direction With Put/Call Ratios.)

At the extremes of the put-call ratio, the opposite of what the majority expects usually happens. As a way of explanation, a high degree of pessimism (a high put-call ratio) usually coincides with a declining market and plenty of cash available for investing, which can quickly lure bargain hunters back into the market.

Let's consider the historical interaction between a 10-day moving average of the put-call ratio and the S&P 500 Index since 2002 (Figure 1). The ratio reached high levels (there were too many pessimists) just at the end of the bear market in the last quarter of 2002. Since then, all peaks and valleys in the ratio correctly forecasted the short-term market swings (except for June 2003 when investors' sentiment shifted radically following the start of the bull market).

Figure 1

Stocks Above Their 50-day Moving Averages
Let us consider the change in a number of stocks in New York trading above their 50-day moving averages. The A50 is an excellent reality check that reveals whether movements in stock prices are broadly based or supported only by a limited number of stocks. The broadly based moves increase the probability that the move will continue, while narrowly based moves suggest a vulnerability to a potential reversal. This is because if the "crowd" gets increasingly excited by only a few stocks, the rally will be built on a shaky foundation. (For more on this, read The Madness Of Crowds and Trading Volume - Crowd Psychology.)

In case of the A50, it is crucial to identify divergences between the A50 and the stock prices. Since 2002, there have been several instances when the A50 diverged significantly from the S&P 500 Index (Figure 2). Twice the divergence predicted an upswing and three times it gave an advanced warning of a forthcoming correction. (For further reading, check out Divergences, Momentum And Rate Of Change.)

Figure 2

Behavioral finance is a relatively young field that offers considerable opportunity for informed investors. In the not-too-distant future, behavioral finance may be formally recognized as the missing link that complements modern finance and explains many market anomalies. Perhaps some market participants will even wonder how it was ever possible to discuss the value of stocks without considering the behavior of buyers and sellers.

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