How To Use Market Sentiment To Improve Your Trading/Investing (Part I)

In my humble opinion, I believe that, as more and more study is conducted into the social aspect of economics, we will ultimately abandon the use of “fundamental analysis” as a main research tool in identifying market direction.  In fact, many noteworthy scholars and economists have begun to recognize that using fundamental analysis to determine market turning points is akin to driving a car blindfolded, while facing the rear window.

As an example, in a paper written by Professor Hernan Cortes Douglas, former Luksic Scholar at Harvard University, former Deputy Research Administrator at the World Bank, and former Senior Economist at the IMF, he noted the following regarding those engaged in “fundamental” analysis for predictive purposes:

The historical data say that they cannot succeed; financial markets never collapse when things look bad. In fact, quite the contrary is true. Before contractions begin, macroeconomic flows always look fine. That is why the vast majority of economists always proclaim the economy to be in excellent health just before it swoons. Despite these failures, indeed despite repeating almost precisely those failures, economists have continued to pore over the same macroeconomic fundamentals for clues to the future. If the conventional macroeconomic approach is useless even in retrospect, if it cannot explain or understand an outcome when we know what it is, has it a prayer of doing so when the goal is assessing the future?

I think all those that are intellectually honest understand the severe limitations in using fundamental analysis for prognostication purposes in a non-linear market.  It is for this reason that I personally turned to the use of market sentiment to assist me in identifying market directional changes.  And, the best methodology that I have found for tracking market sentiment has been that which was discovered by Ralph Nelson Elliott back in the early part of the 20^th century.

Elliott did as much as for market analysis as he did for sociology.  In fact, his discovery of the use of the stock market to provide us with insight into the behavior of man, en masse, is often lost by our quest to use Elliott Wave analysis for profit.  Yet, Elliott’s contribution in this arena is arguably even more important.

In an essay published by Elliot on October 1, 1940, he opened with:

“Civilization rests upon change.   This change is cyclical in origin and characteristics.  A rhythmic series of extreme changes constitutes a cycle.  When a cycle has been completed, another cycle is started.  The rhythm of the new cycle will be the same as that of the previous cycle, although the extent and duration may vary.  The cycle progresses in accordance with the natural law of movement.”

In the first chapter of The Wave Principle, written by A.J. Frost and Robert Prechter, Elliott’s perspective was summarized as follows:

No truth meets more general acceptance than that the universe is ruled by law.  Without law, it is self-evident there would be chaos, and where chaos is, nothing is . . . Man is no less a natural object than the sun or the moon, and his actions, too, in their metrical occurrence, are subject to analysis . . . Very extensive research in connection with  . .  human activities indicates that practically all developments which result from our social-economic processes follow a law that causes them to repeat themselves in similar and constantly recurring serials of waves or impulses of definite number and pattern. . .  The stock market illustrates the wave impulse common to social-economic activity . . . It has its law, just as is true of other things throughout the universe.

So, Elliott recognized that life, as we know it, is cyclical, and constantly rhymes, if not repeats. But, Elliott went so far as to question the causes of these cycles, and has actually turned the common conception of “causation” on its head:

“The causes of these cyclical changes seem clearly to have their origin in the immutable natural law that governs all things, including the various moods of human behavior. Causes, therefore, tend to become relatively unimportant in the long term progress of the cycle.  This fundamental law cannot be subverted or set aside by statutes or restrictions.  Current news and political developments are of only incidental important, soon forgotten; their presumed influence on market trends is not as weighty as is commonly believed.” 

Even though it is now long gone in most people’s memories, we never seem to revisit common “theories” about markets which are paraded before the public and then test them for their intellectual honesty as to the true cause. Remember how focused the entire market was upon the word “patience?”  Remember how much of a difference it was supposed to make upon market direction?

For those of you who do not remember, the leaving out of the word “patience” was supposed to make the market drop, yet, the market rallied.  So, many Fed watchers attempted to spin it as the Fed still being “patient” even though they took out the word “patience.” They then claimed that this was the reason that the market went up.  At the time, I noted how intellectually dishonest this perspective was, as the market was clearly following a sentiment pattern rather than the Fed when it rallied rather than fell.  But, now, we fell below the level from which that rally began only one week ago in the S&P500.  Has everyone now truly lost “patience?”  Yet, our sentiment analysis using Elliott’s analysis methodology was able to publically call for the stock market decline this past week quite accurately, in addition to the rally the prior week.

So, for those that chose to maintain a modicum of intellectual honesty, the Fed action has had nothing to do with the market action of late.  Market sentiment has been directing market action as it always does.   

Ultimately, what Elliott was saying was that external events affect the markets only insofar as they are interpreted by the market participants.  Yet, such interpretation is guided by the prevalent social mood.  Therefore, the important factor to understand is not the social event itself, but, rather, the underlying social mood which will provide the “spin” to an understanding of that external event.

In fact, Elliott even went so far as to state that “At best, news is the tardy recognition of forces that have already been at work for some time and is startling only to those unaware of the trend.”  In effect, what Elliott is saying is that news does not “cause” the cycles, as most believe.  Rather, news falls within the cycles.  While this clearly challenges the common perceptions of what moves markets, I would suggest that all those reading my words at least open their minds to this possibility, and it may very well change the way you invest forever.

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Courtesy of ElliottWaveTrader.net