It is the task of Money Weekend this week to transport the philosophers Aristotle and Plato from the Greek agora of centuries past to today’s stock market. If this sounds like a turn off, stick with us, because your trading account might benefit.
But before we get to those two, there’s the small matter of the US Fed and the glitch in the bull run on the ASX.
Greed and Fear Trading
Stocks actually finished up for the month of February. In fact, the ASX / 200 broke through the 5,000 points mark for the first time since early 2010. And despite a few bumps, it’s managing to hold above that figure. But it is slightly down from the high it hit in the third week of February. You can’t have everything.
It could be thanks to the 2.3% drop in the market following the release of the January minutes from the US Federal Reserve. That spooked markets worldwide. The Fed reminded everyone that stocks look a lot riskier if the US central bank stops pumping money into the system.
Of course, it’s since been written off as an empty threat for now. Uncle Ben Bernanke says the Fed’s actions have helped markets and the economy. And stock markets worldwide recovered. But it was a good reminder of the old notion that there are two things that drive investors: greed and fear. And before the feelings of greed and fear turn up in stock prices, they show up as hormones in human beings.
Now, that might sound a bit out of left field. But hormones might play a much more important role in financial markets than you may think, if John Coates is to be believed. Coates is a former trader with a couple of global banks. He is also a trained neuroscientist. That’s not a usual combination, as far as we know. Coates is also the author of the curious book The Hour Between Dog & Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust.
His book is a kind of speculative theory about biological reactions to financial triggers and risk taking. The key point is that if you want to understand financial markets, you must understand the psychology of traders and investors in the market. And you can’t understand their psychology, he says, unless you understand their biology.
All the Way Back to Ancient Greece
This where Plato and Aristotle come into it. According to Coates, Aristotle studied human behaviour as a whole. But Plato was different. He believed in a distinct divide between the human mind and body. We know now this isn’t true. But the idea hung on over the centuries.
What’s this got to do with today? Coates argues Plato’s line of thinking still shows up in an unlikely place: the assumption of highly rational ‘economic agents’ in today’s most dominant form of economics: the neo-classical school of thought.
This is the economic model Ben Bernanke takes to work every day. It’s how central banks and governments model stock markets and the financial system. Coates calls it ‘economics from the neck up’.
No wonder they miss everything. For our purposes today, it’s the one economic model you don’t want to use approaching the stock market. Remember, the US Federal Reserve misunderstood the Nasdaq bubble, the US subprime crisis and the US housing bubble. If you follow their model, your investments might end up like those.
But there’s another insight in The Hour Between Dog & Wolf that could be worth a lot more from a trading perspective. It’s that experienced traders can develop an advanced skill for anticipating the market.
Remember, there’s the efficient market theory that says stocks only change when news hits the market and then it’s quickly factored into prices. In other words, it’s pointless to try and beat the market. But Coates’ believes experienced traders can and do beat the market consistently.
The emphasis here is on skill, based on learning. But how?
A Time Worn Skill
Coates makes a convincing case that some traders develop expertise as different (but repeating) patterns are stored in their memory bank over a long period of time. The instant feedback of either winning or losing money acts as a reinforcement.
They also learn to master their emotions and stress levels to the point where they can take advantage of volatility in the market. Coates argues there is such a thing as gut reactions or intuition that can be trusted alongside normal rational analysis. Of course, traders like this are rare.
The amateur can’t trade intuitively, or at least shouldn’t. Most amateurs lack trading expertise, for starters. And if the market triggers their stress levels, they’ll be panicked out of positions and will be reluctant to initiate new ones because of the anxiety it creates.
What’s unusual about all this is there are plenty of tales of traders and speculators acting on hunches in the financial markets. Until now, though, there haven’t been many scientists backing them up.
It wouldn’t surprise Slipstream Trader Murray Dawes. He has his own theory of price action that he uses to trade. He’s been doing it for twenty years. That’s a lot of patterns and a lot time studying charts. But it’s also combined with fundamental analysis.
Here’s how he put in just this week on Wednesday:
‘The volatility of stock prices is so intense that a purely fundamental approach will often get you into trouble. That’s because the volatility will either shake you out of the stock at the wrong time or you’ll need to risk a large portion of the stock’s price since you have no idea of when you’re proven wrong. On the other hand, being purely technical means that you could end up playing with fire by buying a stock that is fundamentally unsound.
‘Here’s a weekly chart of the stock in question going back nearly ten years:
A Weekly Price Chart Over Ten Years
Source: Slipstream Trader‘I’ve included some horizontal lines on the chart to show you how I analyse the stock’s price technically. The key levels are the solid blue lines based on the range created all the way back in 2006 between $1.00 and $1.64. The dotted line in between is called the ‘point of control’ and is what I see as the gravitational point around which all of the subsequent price action oscillates. Using this method I have a point of reference for analysing the past ten year’s price action.’
Murray thinks amateur traders do try to read the market, but they read it in the wrong way. He’s going to shed some more light on his theory with a report shortly.
Callum Newman
Editor, Money Weekend
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