“Assumption” you say? “It isn’t an assumption Denise! It is truth!” Oh really?

First, if it is such a natural truth – like gravity or the sun rising in the east – then why is it so unnatural to do it? Why do day-traders fail at it at an alarming rate while institutions (with their MBA’s and statisticians) also fail at it has been demonstrated through the now 1000’s of behavioral finance studies and real world examples?

Aside from that basic question is the even more important one of “how does the human brain most successfully process market data“? And luckily The Journal of Finance has finally decided to publish what in my opinion is essentially earth-shattering research by Quartz, Bossaerts and Bruguier of The California Institute of Technology. This seminal and singular piece of research sheds a whole new light on the neurological processes involved in accurately reading markets. (And to boot it in turn explains why so many traders fail and why so many institutional traders can get it wrong!)

In short, …”tests show that Theory of Mind (ToM), rather than mathematical, abilities are better predictors of success in forecasting stock markets“.

Of course this begs the question… “what does that mean”? ToM is basically the ability to read other people. It is the mental capacity where you can imagine/see/”know” what they are thinking and feeling and therefore be better predictors of their coming choices of action. (See wikipedia)

In other words, if we go back and look for example at a very public decision – that of Hank Paulson to let Lehman go bankrupt – it had everything to do with the pressure he was under over the idea of “moral hazard” and very little to do with anything else.

Now that example doesn’t help you much when the market is slow and plodding and range bound but I use it because in retrospect it helps people see how a concerted effort in the Summer of 2008 to understand the human dynamics of the decision makers scenarios would have yielded a better idea about what was likely to happen. What I mean by that is if you specifically tried to play out the possibilities post Bear Stearns and pre-Lehman…. you would have come up with “they let at least one bank fail”. Once you had that idea you could see AIG was going down too!

Conversely all the modeling and probability thinking in the world would NEVER have gotten you there!

You can read the original research yourself @ Encoding Financial Signals in the Brain … or on the Social Science Research Network. (The latter compels me to point out that Antoine (Tony), whom I have been bugging for over two years about this, is an Electrical Engineer and he was kind enough to email me this week and let me know the paper had finally been accepted!)

Now the question is how much will the behavioral finance tendencies of status-quo and confirmation bias kick in … and prevent a large majority of people who care about reading markets from really grasping how to capitalize on an assumption turned upside down?

The “thing” that is different about both this hypothesis and my way of looking at the markets is this. I begin my thinking with the question of “what are they or will they be doing”? In other words, I always ask the human question FIRST.

I do this for a couple of reasons. 1) It is actually the only thing we care about – except 99.85% of the traders and investors never think of it. 2) Recent research shows that “Theory of Mind” (the ability to understand the other) is a more applicable skill to market prediction than thinking in probabilities.

Now I have almost 15 years of trading experience and I learned from a tape reader (btw …what is tape reading but “reading” what “they” are doing), so I can look at my screens and unconsciously come up with a good answer to the human question. But it is totally fair to ask me to deconstruct it?

For example, the $TICK and the Adv/Decline line or chart are both revealing what traders in the NYSE cash equity markets are doing. Now, who trades those? Basically you have two maybe three groups – the vast retail public and the hedge funds (and prop desks). It used to be that the S&P futures would lead the cash market but it is my experience that in recent years, this “cash” leads the futures. I attribute this to lots more short-term trading by hedge funds.

2nd – the Naz and Russell are different animals from the S&P 500 – so I consider those traders/groups as a different group of people. If they are turning the ship in the exact same way at the exact same time, then the boat is going to move. If they are pulling in a little bit of the opposite direction, then the boat won’t go so fast. It might even do a 180. When I look at the VIX (which I haven’t lately but not for any great reason), I consider that a 3rd group – the equity option people. Same ideas though.

Now all of this can be labeled under convergence/divergence but I like to have my decisions be based on the most irreducible analysis which in the markets is always people – i.e. it can’t get any simpler than that.

So take elements like volume. Well now, what is volume but a representation of how many people traded how many contracts in a given period or at a given price? (which is why I like the market development/market profile method) You can count on the price coming back to a high volume area or an area that everyone knows (yesterday’s low) and being defended. Why do gaps work? Well… because there are less trades there to be defended – and because now we all expect them to work. In other words, real people who bought or sold at a certain price – or who had the opportunity to get in or out at a price but didn’t – will react when the market gets back to that price again. Some will be adding to defend and some will be adding out of relief (it works short or long).

You can also ask questions like “are there as many people selling at this price now as there were this morning or did that huge volume bar just wipe out all the shorts” – at least until a group of real people have time to recover and re-load.

So… do I use probabilities? At this point, I really only use them intuitively. Do I think they are valuable? YES but nevertheless, the real clue is that the numbers (and the bars and lines they draw) are only a clue – not the real answer.

Hope that helps – DKS